Office of Financial Research's Annual Report to Congress 2020
ANNUAL REPORT TO CONGRESS 2020
FROM THE DIRECTOR
This year brought a financial environment of rapid and periodically unpredictable change. Unlike previous Annual Reports from the Office of Financial Research (OFR), this year’s report is unique in that it was written in the wake of a material threat to financial stability.
Economic indicators on the eve of the global pandemic showed little if any concern about a slowdown, let alone a sharp but short economic contraction. For example, the U.S. civilian unemployment rate for February 2020 dropped to a 50-year low of 3.5 percent. It then spiked to 14.7 percent just two months later.
Over the turbulent months since the start of the COVID-19 pandemic, our Office’s mission has never been more clear or important. As COVID-19-related disruptions evolve, our Office’s data and research products will continue to provide timely indicators of financial stress for the Financial Stability Oversight Council (FSOC) and its members.
Following my confirmation in 2019, OFR prioritized an all-staff effort to dutifully fulfill our Dodd-Frank Act responsibilities. While our mission is simple, it
FROM THE DIRECTOR i is essential — that is, to further financial stability through the analysis of informative financial data, as well as the advancement of data standards and products, principally in support of FSOC and its members. Indeed, throughout the turbulent months that began in February of this year, the value that our Office has provided to FSOC and its members has increased and deepened considerably from already consequential levels.
Reviewing my first full year as Director, I am proud of the important work that members of our staff have accomplished, and confident that our path forward will continue to find OFR leading the development of advanced research insights and data services.
OFR monitors and analyzes both potential and realized stressors in financial markets and institutions, with the objective of clarifying the cause and extent of any associated vulnerabilities. Our Office plays a complementary role in supporting financial stability, which is always important, and especially so during the natural disaster triggered by COVID-19.
Throughout the serious difficulties that COVID-19 brought to our health, economic, and financial sectors, our Office continued to build on its important work. For example, over a decade ago, the Dodd-Frank Act established a legislative mandate for OFR to build a Financial Instrument Reference Database (FIRD), but that mandate lay dormant until
ii OFR ANNUAL REPORT TO CONGRESS 2020 now. This year, our Office made significant progress toward making this mandate a reality.
Our team continues to make valuable contributions as members of FSOC’s Systemic Risk and Data Committees, while continuing to collaborate with individual member offices throughout. OFR’s Data Center began releasing cleared repo data and launched our Office’s Short-term Funding Monitor — an interactive tool that reliably delivers a more complete view of short-term funding markets. And furthermore, our Office added important enhancements to our Bank Systemic Risk Monitor, which tracks systemic risks that interconnections among the largest banks can create.
In addition, our Office’s international leadership within the Legal Entity Identifier (LEI) continues to further the adoption and integrity of data standards that bring greater transparency and efficiency to financial markets worldwide.
Contributions to our annual report have come from every part of our Office. I am proud of this good work and whole-team effort, and even more so during the fallout from a global pandemic and sharp but short economic recession.
I am grateful for the integrity that our staff members bring to our Office each and every day. Without it, we cannot do our best work. With it, we will
FROM THE DIRECTOR iii continually strengthen our Office’s support of FSOC and its members by building on our Office’s organizational excellence, and furthering our culture of accountability and professionalism at every level.
Finally, let’s always remember why we engage this mission — because when and where financial stability is compromised, economic opportunities go missing throughout our society. And the impact can be especially acute for low- and moderate-income households that may have trouble weathering emergencies, lack opportunities for economic mobility, or face high hurdles to improve life chances for children. As we turn to further recovery, OFR will continue to fulfill its mission by strengthening financial stability, and ultimately economic opportunity.
Dino Falaschetti Director, Office of Financial Research
iv OFR ANNUAL REPORT TO CONGRESS 2020
TABLE OF CONTENTS
FROM THE DIRECTOR i
SUMMARY: OFR 2020 ANNUAL REPORT TO CONGRESS 3 Assessing Financial Risks in a Turbulent Year 4 Assessing Financial Risks and Uncertainty 5 Exploration of Information Markets 6 The OFR’s Performance 7
PART ONE: ASSESSING FINANCIAL RISKS IN A TURBULENT YEAR 11 COVID-19 and the Financial Crisis of 2020 11 Financial Stability and Economic Opportunity 21 Why Is Financial Stability Important? 21 How Does the COVID-19 Pandemic Threaten that Stability? 21 How Have Previous Crises Threatened Financial Stability and Economic Opportunity? 22 How Can Financial Stability Be Maintained? 24
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 29 Summary of Risks 29 Macroeconomic Risk 30 U.S. Economic Conditions 31 Global Economic Conditions 34 Policy Responses 36 Uncertainty Prevails 37 Credit Risk 38 Nonfinancial Corporate Credit 39 Household Credit 53 Residential Real Estate 56 State and Local Debt 60 Pension Funds 62 Foreign Government Debt 65 Market Risk 68 Stock Markets 68 Derivatives Markets 69 Bond Markets 70 Liquidity and Funding Risk 73 Financial Institutions 73 Financial Markets 77 Leverage in the Financial System 84 Banks 84 Insurance Companies 85 Hedge Funds 85 Financial Firm Insolvency Risk and Potential Contagion 89 Financial Firm Insolvency Risk 89 Contagion Risk Within the Financial System 94 Cybersecurity Risk 98 Financial Services Sector Use of Information Technology 99 Cyber Contagion and Concentration Risks 100 Emerging Quantum Computing Risk 101 Improving Financial System Cybersecurity 102 Additional Risks 102 Natural Disasters 102 Transition from LIBOR to Alternative Reference Rates 103 U.K. Exit from the European Union 105
PART THREE: EXPLORATION OF INFORMATION MARKETS 109 The Roots of Systemic Risk 110 How Information Markets Might Complement Systemic Risk Management 112
PART FOUR: THE OFR’S PERFORMANCE 119 A Year of Mission Focus 119 A New Strategic Plan 119 Steady Progress 119 International Leadership in Cross-border Financial Data Standards 119 Greater Adoption of the Legal Entity Identifier (LEI) by Governments and the Private Sector 119 Improved LEI Data Quality 120 Establishment of New Cross-border Financial Data Standards 120 Data Products and Innovations 121 U.S. Repo Markets Data Release and the Short-term Funding Monitor (STFM) 122 Financial Stress Index (FSI) 124 U.S. Money Market Fund (MMF) Monitor 124 Interagency Data Inventory 124 Bank Systemic Risk Monitor (BSRM) 124 Financial Instrument Reference Database (FIRD) 125 Collaboration 126 Support for the Financial Stability Oversight Council and Its Members 126 Financial Research Advisory Committee (FRAC) 126 Standards Bodies and Public Forums 126 Conferences Cosponsored 128 Information Technology (IT) 128 Cloud Resources and Increased Capabilities 128 Remote Capabilities 128 Data Collection and Management 128 Data and Information Security 129 OFR Organization 129 Growth Management 130 Budget 131
GLOSSARY 135
ENDNOTES 153
BIBLIOGRAPHY 167
All data cited in this report are as of Sept. 30, 2020, unless otherwise noted.
SUMMARY: OFR 2020 ANNUAL REPORT TO CONGRESS
SUMMARY: OFR 2020 ANNUAL REPORT TO CONGRESS
With this report, the Office of Financial Research (OFR) presents its assessment of the state of the U.S. financial system, as required by the Dodd- Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). The 2020 Annual Report to Congress fulfills OFR’s requirement to submit a report to Congress within 120 days of the close of the fiscal year (FY). All data cited in this report are as of Sept. 30, 2020, unless otherwise noted. This report also reflects the OFR’s duty to inform policymakers, regulators, market participants, and the American public about its work to monitor, investigate, and report on changes in systemwide financial stability risk levels and patterns. The OFR’s efforts support sound risk management for the entire financial system. For FY 2020, the report is organized into four main parts:
Assessing Financial 1 Risks in a Turbulent Year Assessing Financial 2 Risks and Uncertainty Exploration of 3 Information Markets The OFR’s 4 Performance
SUMMARY 3 Assessing Financial Risks 1 in a Turbulent Year
It has been a decade since economic, and financial the OFR was established effects. During March, the and this report is presented medical crisis prompted U.S. during a time of financial state and local government of gross domestic product and economic uncertainty decisions to declare stay- at the end of FY 2020 from that is a first for the Office. at-home orders and order 79 percent at the end of FY The OFR’s data, research, the shutdown of many 2019. and monitoring expertise businesses. The pandemic was well-utilized this year and efforts to contain the As this report goes to and played an important health threat drastically press, America’s economy role in identifying and curtailed economic activity has climbed rapidly back understanding how and severely stressed from the short but steep stresses within the U.S. financial markets. On March COVID-19 recession. And financial system during 9, 12, and 16, the Dow while our economy retraces March 2020 interacted with Jones Industrial Average, its way back to trends vulnerabilities identified in for example, experienced that characterized the previous years. Government some of the worst price pre-pandemic economy, financial system downturns in its history. it will contend with interventions developed heightened uncertainty The economy, and even during the 2007-09 financial and heterogeneous effects more financial markets, crisis proved instrumental across sectors and firms quickly made substantial in moderating the effects within sectors. Extraordinary recoveries with the help of this year’s financial government and monetary of massive government turbulence. policy support has gone support. The Federal far to moderate damage The cause of this year’s Reserve’s balance sheet to our economy. But while financial instability is novel. ballooned to $7 trillion, that support helped bridge Within months of the new by far an all-time high and a period of heightened year, it became clear that almost double its size from economic turbulence, it the COVID-19 pandemic a year earlier, while federal could also risk distortions would be global and debt held by the public rose to competitive markets if trigger devastating health, to an estimated 99 percent maintained too long.
4 OFR ANNUAL REPORT TO CONGRESS 2020 risky-asset valuations heightened market risk. Leverage within the financial sector rose modestly while remaining constrained Assessing Financial Risks since the 2007-09 crisis. 2 and Uncertainty Insolvency and contagion risks for financial firms appear to be contained while these firms maintain high capital and liquidity The OFR’s financial stability Despite government actions buffers. assessment, combined to stabilize the economy, Cyber risks have continued with key findings from as well as the finances to grow in volume and its financial system of firms and households, sophistication. New surveillance, evaluations macroeconomic and credit vulnerabilities could emerge of system vulnerabilities, risks remain high. The from increased reliance data analysis, and research, pandemic’s course remains on remote work, as well supports its view that uncertain, and thus, so must as automated systems potential risks persist and the economic recovery. that strain financial firms’ remain elevated in most Leverage is high among telecommunications of the categories OFR nonfinancial firms, with the capacity or that operate monitors. These areas of potential for severe defaults outside these firms’ control. risk include macroeconomic, within the commercial real Natural disasters, the United credit, market, liquidity estate, energy, and high- Kingdom’s exit from the and funding, leverage, touch service sectors. European Union, and the insolvency and potential transition from LIBOR to contagion, cybersecurity, Liquidity and funding risks alternative reference rates and additional risks not moderated quickly after for financial instruments, included in the other the Federal Reserve’s also remain potential categories. The COVID-19 mid-March intervention sources of risk to financial pandemic increased most, if announcements, while a stability. not all, of these risks. midyear return to elevated
SUMMARY 5 Exploration of 3 Information Markets
Traditional approaches to move constraints against managing systemic risks efficiently reducing the rely to a considerable possibility, and mitigating extent on regulation, the severity, of threats to capital requirements, and financial stability. oversight. People who are charged with enacting A market for information these strategies, however, about prospects for can face political forces realizing systemic risks that favor distributional could weaken the incentive preferences over more for creditors to run on general opportunity. In financial organizations. addition, they may work Information markets might at a considerable distance also be structured to better from local knowledge that evaluate whether proposed can help gauge reliance of or enacted policies and financiers on each other for regulations can reduce funding, the concentration systemic risks in a cost- of asset holdings across effective manner. Finally, financiers, and the this latter type of market likelihood that adverse could increase transparency news about one financier’s about winners and losers solvency can encourage from such policies and runs on another’s liabilities. regulations, and thus help Top-down approaches to more productive regulations managing systemic risk may overcome distributional thus face tight and hard-to- inefficiencies.
6 OFR ANNUAL REPORT TO CONGRESS 2020 services, research insights, and analysis helped address the turbulence of 2020. Among the Office’s online public monitors, the The OFR’s Financial Stress Index (FSI) 4 Performance provided, and continues to produce, daily indicators of financial system stress.
The Office also expanded its monitor offerings in 2020. OFR promotes financial international leadership The U.S. Repo Markets stability by delivering in cross-border financial Data Release and the Short- high-quality financial data, data standards and the term Funding Monitor were standards, and analysis innovation of several launched during the fourth principally to support essential data products quarter. Together, they the Financial Stability and initiatives. In 2020, the provide new insights into Oversight Council (FSOC) Legal Entity Identifier (LEI) short-term funding, the core and its members. This reached its goal of global of liquidity and maturity year the OFR published preeminence as a high- transformation in financial its FY2020-2024 Strategic quality identifier for financial markets. Also this year, the Plan, which consists of firms. The OFR served Bank Systemic Risk Monitor two goals: 1) Support on the LEI’s Regulatory (BSRM) was upgraded and the Financial Stability Oversight Committee the Financial Instrument Work of the FSOC and (ROC), which continued to Reference Database (FIRD) 2) Further Organizational focus on the quality of data entered its initial phase of Excellence. The plan is that underlies the LEI. This development. designed to accommodate past year, the ROC took the changing needs of on the role of governance Years of migrating our the OFR’s stakeholders for a trio of new financial Office’s information as they address financial data standards: the Unique technology to the cloud, vulnerabilities, stress, and Transaction Identifier and furthering significant even crises, as well as (UTI), the Unique Product system advances, proved evolving financial business Identifier (UPI), and the prescient in preparation models. Critical Data Elements for for the pandemic. over-the-counter derivatives Throughout this period, Our performance reporting (CDE). employee engagement measures and indicators and productivity were provided a solid picture The OFR’s ability to exceptional, as our Office of OFR’s progress toward equip the FSOC and its continued to advance objectives, goals, and members with germane operational excellence and mission achievement this data collections, financial superior teamwork. year. Highlights include stability monitoring
SUMMARY 7 The OFR obligated $62.69 million in FY 2020 — 42 percent for labor and 58 percent for other expenses. A large portion of the nonlabor figure was due to significant OFR expenses, particularly in the Technology Center ($23.4 million), which support the OFR’s unique mandates. Office staff totaled 107 as of Sept. 30, 2020.
8 OFR ANNUAL REPORT TO CONGRESS 2020 PART ONE: ASSESSING FINANCIAL RISKS IN A TURBULENT YEAR
PART ONE: ASSESSING FINANCIAL RISKS IN A TURBULENT YEAR
COVID-19 AND THE to return to more normal virus that rapidly became a FINANCIAL CRISIS OF functioning. Such global pandemic, resulting government interventions in growing infections; 2020 can serve as a safety net deaths; great public fear; in the near term, but and disruptions to families, This year’s Annual Report they should not impede businesses, and lives marks the first time the a return to competitively worldwide. Office of Financial Research priced market rewards and has published its financial losses. Indeed, as long as In response came stability assessment during government intervention aggressive and a year when financial is necessary to keep the unprecedented government markets encountered financial system functional, actions to combat the extreme turbulence. We our economy cannot fully pandemic. The pandemic thus begin Part 1 of our return to normal. As of the itself, combined with these report by reviewing the date of this report, many actions, had severe short- financial stress so vividly of these interventions term economic costs, experienced this spring. had ended or were being including a steep recession. unwound. More than 50 million March of this year saw U.S. people lost their jobs, financial markets experience This threat to stability in many companies filed for sharp and sudden 2020 had an origin different bankruptcy or restructured disruptions, as well as falling from the financial crisis of their operations, and asset prices. COVID-19, 2007-09, the international many sectors experienced the disease caused by a debt crises of the 1990s, sharp declines. Financial novel coronavirus, stalled the mortgage and sovereign markets, anticipating the an economy that was hitting debt crises of the 1980s, the economic effects and faced on all cylinders just a month oil crises of the 1970s, the with massive uncertainty, before, and ended an economic collapse of the experienced considerable expansion that had lasted 1930s, the panic of 1907, or turbulence in March. The more than 10 years. A series various 19th century panics. 2020 threat to stability of extraordinary monetary This time, the trigger was started with the COVID-19 and fiscal interventions exogenous to the financial crisis, which brought allowed financial markets system — a new, virulent material knock-on effects to
PART ONE: ASSESSING FINANCIAL RISKS IN A TURBULENT YEAR 11 our economy and financial Economic and Health Risks of mortgage loans, that sector. of Pandemics), none of the the travel industry would financial stability reports collapse, or many other This latest threat to stability linked that knowledge to 2020 surprises. The financial and its ongoing effects the possibility of financial travails of the State of forcefully underline the instability and a new Illinois were well known, lesson that efforts to assess financial crisis. but no one imagined it financial stability always would be borrowing more confront an economic and These reports discussed than $1 billion from the financial future marked by numerous relevant Federal Reserve. And no fundamental uncertainty vulnerabilities — notably, one, including the Federal and thus subject to sharp increases in asset prices and Reserve itself, forecast a surprises. In particular, a risk leverage, partially because Federal Reserve balance assessment done now must of long periods of very low, sheet that would expand to likewise reflect substantial even negative, interest $7 trillion (see Figure 1). continuing uncertainties. rates. U.S. reports correctly pointed out the risks of debt This record shows the In 2019, about 30 central securitization, particularly difference between correctly banks, multilateral for nonbank mortgage perceiving vulnerabilities organizations, and servicers and collateralized and correctly predicting government agencies loan obligations (CLOs). a crisis and the extent of around the world issued However, none could or did a crisis. Financial systems official financial stability anticipate, for example, that with only moderate reports, including the Congress would mandate perceived risks were hit by OFR. Applying substantial forbearance on millions the unexpected shocks of expertise and knowledge, these reports attempted Figure 1. Federal Reserve Balance Sheet Reached to size up and anticipate Unprecedented Size in 2020 ($ trillions) systemic risk. Displaying the difficulty of these efforts, 8 most assessed risks as “moderate.” Not one of 6 these reports predicted a financial crisis in 2020, or 4 a significant probability of one. Not one highlighted 2 the potential for a new pandemic to threaten financial stability. Although 0 the possibility, even the high Jan Jan Jan Jan Jan Jan Jan Jan probability in time, of the 2006 2008 2010 2012 2014 2016 2018 2020 emergence of new viruses Note: Total Federal Reserve System assets from Release H.4.1. and pandemics was well Sources: Board of Governors of the Federal Reserve System, Federal Reserve Bank of St. Louis, known (see Mitigating the Office of Financial Research
12 OFR ANNUAL REPORT TO CONGRESS 2020 the global pandemic and governments’ responses Figure 2. Asset Prices Plunged, But Recovered (indexes) to control it, with severe 110 and unexpected financial reactions. 100
This year’s disruptions 90 reconfirm that no financial 80 system, however structured, Stocks can avoid instability when 70 Bonds large numbers of financial REITs actors all try to move into 60 Commodities cash at once — any more 50 than banks, as is universally Feb Mar Apr May Jun Jul Aug Sep observed, can survive intact 2020 2020 2020 2020 2020 2020 2020 2020 a run on their liabilities. Note: Index values set to 100 on Feb. 19, 2020. Stocks are S&P 500 Index, bonds The “dash to cash” in are Dow Jones Corporate Bond Index, real estate investment trusts (REITs) are S&P 500 Real Estate Investment Trust Index, and commodities are S&P GSCI March took place with Index. breathtaking speed. Asset Sources: Dow Jones Corporation, Standard & Poors, Haver Analytics, Office of Financial Research sales and redemptions of funds by investors were Figure 3). The spike in Figure 3. Spike in TED accompanied by unusually unemployment and plunge Spread Marked Liquidity high market volatility and in economic activity that Crisis (percent) reduced lending by financial quickly followed brought institutions. High market sharp declines in the prices 1.6 volatility, in turn, resulted in of commodities, including margin calls that contributed further declines in the price 1.2 to a sell-off of even Treasury of oil. All financial actors securities to raise cash. faced extreme uncertainty. 0.8 Prices of riskier assets fell In short, 2020 brought sharply, with no asset class 0.4 entirely unexpected financial left untouched (see Figure turbulence and ongoing 0.0 2). Treasury and repurchase economic and financial risks. agreement (repo) markets Jan Mar May Jul Sep 2020 2020 2020 2020 2020 were distorted by the The Federal Reserve, global need for cash. Bank Administration, and Note: The TED spread is the lines of credit were heavily difference between the three-month Congress responded by U.S. dollar LIBOR and Treasury bill drawn down to raise cash. providing vast market and rates. It is an indicator of liquidity in Some borrowers accessed economic support. This the interbank market, where large credit lines strategically as international banks lend money support addressed both among themselves. defensive draws. Scarce the lack of market liquidity Sources: Federal Reserve Bank of St. Louis, liquidity was reflected in and the need for financing Office of Financial Research interbank spreads (see
PART ONE: ASSESSING FINANCIAL RISKS IN A TURBULENT YEAR 13 MITIGATING THE ECONOMIC AND HEALTH RISKS OF PANDEMICS
There were four influenza pandemics over the 100 years ending 2019, which translates to a 4 percent per year probability of pandemic influenza. The Council of Economic Advisers (CEA) reported in September 2019 that future influenza pandemics, depending on the transmission efficiency and virulence of the virus, could cause economic damage ranging from $413 billion to $3.79 trillion over the course of a year.1 Large-scale, immediate immunization is the most effective way to control the spread of influenza, but that is obviously not possible if there is no effective vaccine. The CEA found that technologies that could deliver sufficient doses of more effective vaccine at the outset of an influenza pandemic could produce as much as a $953 billion benefit for Americans — about half the total cost of an average pandemic. For various reasons, private market incentives alone are insufficient to develop and deploy such new vaccine technologies. The CEA recommended public-private partnerships such as those instituted this year to cope with the COVID-19 pandemic.
economic activity at the Figure 4. Stock and Bond Markets Recovered (indexes) onset of a steep recession (see Federal Reserve 3,600 Federal Reserve Actions to Support Markets 3,400 interventions and Credit Availability). 3,200 These massive liquidity 3,000 interventions carried out on an exceptional 2,800 scale followed the classic 2,600 S&P 500 prescription from Walter ICE BaML Bond 2,400 Bagehot, the 19th century creator of central banking 2,200 theory, to “lend freely” 2,000 to quell a panic. Within Jan Mar May Jul Sep two months they led to 2020 2020 2020 2020 2020 generally stabilized equity, debt, and funding markets, Note: The ICE BaML Bond index is the Corporate Master Total Return Bond Index. with a notable recovery in equity and bond prices (see Sources: Intercontinental Exchange, Standard & Poor’s, Haver Analytics, Office of Financial Research Figure 4) and a dramatic financial markets with actors, on one hand, and on narrowing of risk spreads. “organic liquidity” reflecting the other, those requiring However, there is an the ongoing competitive what we may call “synthetic essential difference between market buying, selling, liquidity,” which are and risk bearing by private dependent on large official
14 OFR ANNUAL REPORT TO CONGRESS 2020 interventions and public absorption of financial Figure 5. U.S. Unemployment Rate Since 1948 (percent) risk. The latter, along with 16 fiscal support, induced the April-May financial market November 1982: 10.8% recoveries. The objective 12 September 2020: 7.9% of this synthetic liquidity was to create safe passage through the pandemic and 8 shutdowns until organic liquidity returns. There remains a striking 4 contrast between the quick recovery of financial markets and the slower recovery 0 of the economy, which 1948 1960 1972 1984 1996 2008 2020 experienced the highest Sources: Bureau of Labor Statistics, Office of Financial Research
Figure 6. Economic Activity Stayed Weak as Financial Markets Rebounded (indexes)
12 OFR Financial Stress Index 3/23: Federal Reserve Weekly Economic Index says it will buy Treasuries, 8 corporate debt 9/2: Stock market Market 4 indexes set new highs volatility
0 Week ended 3/20: -4 Shutdowns spread
2/29: First April-May: Job -8 reported U.S. death losses continue Summer: Some jobs return with reopenings -12 Jan Feb Mar Apr May Jun Jul Aug Sep 2020 2020 2020 2020 2020 2020 2020 2020 2020
Note: The Weekly Economic Index is an index of 10 daily and weekly economic indicators. It reflects what annualized percent change in gross domestic product would be if conditions persisted for a quarter. The OFR Financial Stress Index measures systemwide stress. It is above zero when stress levels are above average, and below zero when stress levels are below average.
Sources: Federal Reserve Bank of New York, Office of Financial Research
PART ONE: ASSESSING FINANCIAL RISKS IN A TURBULENT YEAR 15 unemployment rate since but the increase in risk losses had dramatically World War II (see Figures is uneven across firms. escalated (see Figures 7 5 and 6). The possibility The riskiest firms suffer and 8 and Current Expected remains for heavy ongoing a disproportionate rise Credit Loss Accounting credit losses and failures. in borrowing costs when Framework). Consumer spending and a shock hits. While the In sum, the reality of business investment face financial services industry COVID-19 disruptions was pervasive uncertainty about played a large role in worse than the most severe the course of the pandemic 2007-09, consumer goods stress tests projected. We and its consequences. and services firms were now appear to be moving most affected this year. Credit risk is a primary from having stabilized concern going forward. Also reflecting increased markets to addressing Credit default swap (CDS) credit risk, as of September ongoing stresses in prices began signaling 30 the stock prices of many sectors, potentially stress in the corporate banks were down 36 heavy credit losses, and credit market during March. percent from the start of heightened business The median single-name the year, and as of June failures. CDS spread rises in crises, 30 their provisions for loan
Figure 7. Bank Stock Figure 8. Bank Provisions for Credit Losses Rose Sharply Prices Tumbled, Reflecting ($ billions) Investor Concerns (index) 80 120
60 80
40 40
0 20 Jan Mar May Jul Sep 2020 2020 2020 2020 2020
Note: KBW Nasdaq Bank Index, which 0 tracks 24 publicly traded banking 1985 1990 1995 2000 2005 2010 2015 2020 stocks representing the large U.S. national money center banks, regional banks, and thrift institutions. Note: Data as of June 30, 2020. Includes all FDIC-insured institutions. Provisions in 2020, in part, reflect adoption of the current expected credit loss accounting Sources: Nasdaq, Office of Financial Research framework among many larger banks.
Sources: Federal Deposit Insurance Corporation, Haver Analytics, Office of Financial Research
16 OFR ANNUAL REPORT TO CONGRESS 2020 FEDERAL RESERVE ACTIONS TO SUPPORT MARKETS AND CREDIT AVAILABILITY
The Federal Reserve took a very aggressive series of actions to support the financial system through the effects of the pandemic. The Federal Reserve started by announcing changes to standing facilities and programs to provide liquidity. The Federal Reserve Bank of New York expanded its repurchase agreement operations. The Federal Reserve also lowered the primary credit rate, the interest rate it charges most banks at the discount window, from 1.75 percent to 0.25 percent. It also extended credit for up to 90 days rather than 30 days, and encouraged banks to use the window and intraday credit from the Federal Reserve. It also took steps to ease bank capital and liquidity buffers and reserve requirements.
The Federal Reserve also announced changes to enhance the provision of U.S. dollar liquidity through its standing U.S. dollar swap line arrangements. These swap lines are standing facilities with key foreign central banks. The lines allow those central banks to exchange domestic currency for U.S. dollars to satisfy the dollar liquidity demand of local banks and businesses. Later, the Federal Reserve expanded the set of central banks with which it has swap lines. It also created the Foreign and International Monetary Authorities (FIMA) Repo Facility, which allows foreign central banks and international monetary authorities with which the Federal Reserve doesn’t have swap agreements to borrow dollars against Treasury securities instead of selling those securities.
To stabilize short-term funding markets, the Federal Reserve reestablished several credit facilities that were first used in the 2007-09 financial crisis. Some were set up under the Federal Reserve’s emergency section 13(3) authority with the funding approval of the Treasury Secretary. Others were established by Title IV of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), with the funding approval of the Treasury Secretary. Although the facilities did not go into effect for days or weeks, market conditions began to improve with the initial announcements in mid-March that they would be available.
• Under the Primary Dealer Credit Facility (PDCF), the Federal Reserve Bank of New York made collateralized loans to primary dealers, which are the banks and securities broker-dealers designated to serve as trading counterparties in carrying out U.S. monetary policy.
PART ONE: ASSESSING FINANCIAL RISKS IN A TURBULENT YEAR 17 • The Money Market Mutual Fund Liquidity Facility (MMLF) allowed the Federal Reserve Bank of Boston to provide loans to eligible financial institutions to purchase assets from certain types of money market funds. • The Commercial Paper Funding Facility (CPFF) financed commercial paper issuance. Primary dealers serve as intermediaries for issuance requests.
The Federal Reserve also acted to support the flow of credit to households and businesses. It expanded the scope of existing facilities and created mostly new credit facilities, also under its section 13(3) authority.
• The Term Asset-Backed Securities Loan Facility (TALF) financed the issuance of securitized auto loans, equipment leases, credit card loans, and other loans. The TALF was used during the 2008 crisis, from March 2009 until June 2010. • The Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF) provided support to corporate bond markets. The PMCCF stood ready to purchase new bonds and loans issued by corporations, while the SMCCF supported trading of existing corporate bonds. The SMCCF also purchased corporate bond exchange-traded funds. • The Paycheck Protection Program Liquidity Facility (PPPLF) allowed the Federal Reserve Banks to extend credit to lenders participating in the Small Business Administration’s Paycheck Protection Program (PPP). The PPP provided potentially forgivable loans to small businesses so that they can keep their workers on the payroll. The PPPLF was designed to bolster the effectiveness of the PPP. • The Main Street Lending Program included three facilities to support small and medium-size businesses and their employees – that is, the Main Street New Loan Facility (MSNLF), the Main Street Expanded Loan Facility (MSELF), and the Main Street Priority Loan Facility (MSPLF). In July, the Federal Reserve added facilities to lend to nonprofit organizations, the Nonprofit New Loan Facility and the Nonprofit Expanded Loan Facility. • The Municipal Liquidity Facility (MLF) allowed the Federal Reserve to buy up to $500 billion in short-term debt issued by state and local governments, with loss protection provided by the U.S. Treasury. This program helped municipalities borrow for their unexpected cash needs
18 OFR ANNUAL REPORT TO CONGRESS 2020 during the crisis. To date, there have been two borrowers, both experiencing severe financial stress: the State of Illinois and the New York Metropolitan Transportation Authority.
The use of the various facilities reflected the degree of stress on the economy and financial sector over time (see Figure 9). Vulnerabilities remain from the uncertain course of the virus and the economic and political responses to it. The Federal Reserve’s ability to quickly extend or reinstate any of these steps is a source of market support.
Figure 9. Credit and Liquidity Facility Use ($ billions)
1,000 CPFF CC PPPLF 800 MMLF PDCF 600 Repo Discount window
400
200
0 3/18/20 4/29/20 6/10/20 7/22/20 9/2/20
Note: Includes primary discount window lending and the various repurchase agreement (repo), Primary Dealer Credit (PDCF), Money Market Mutual Fund Liquidity (MMLF), Paycheck Protection Program Liquidity (PPPLF), Corporate Credit (CC), and Commercial Paper Funding (CPFF) facilities.
Sources: Board of Governors of the Federal Reserve System, Haver Analytics, Office of Financial Research
PART ONE: ASSESSING FINANCIAL RISKS IN A TURBULENT YEAR 19 At the same time, the Federal Reserve continues to hold more than $4 trillion in Treasury securities, $2 trillion in mortgage securities, and total assets of $7 trillion (see Figure 10).
The longer term effects of these interventions remain uncertain.
Figure 10. Federal Reserve Assets ($ trillions)
7 Treasury securities 6 Mortgage-backed securities Premiums/discounts on holdings 5 Holdings of 2008-09 or 2020 rescue programs Repo/loans 4 Other assets
3
2
1
0 Sep Sep Sep Sep 2000 2010 2019 2020
Note: Data as of week including September 30 for Federal Reserve System assets. Treasury securities also include other federal debt securities. Mortgage- backed securities are backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Premiums/discounts are unamortized differences between purchase price and face value of securities held. Holdings of 2020 programs are net holdings of Commercial Paper Funding Facility II, Corporate Credit Facilities, Main Street Facilities, Municipal Liquidity Facility, and TALF II; holdings of 2008-09 programs are net holdings of several programs established during that financial crisis. Repo/loans includes cash value of repurchase agreements collateralized by Treasury and federal agency securities, plus loans through Primary Dealer Credit Facility, Money Market Mutual Fund Liquidity Facility, Paycheck Protection Program Liquidity Facility, and other credit extensions. Other assets are all other assets as reported on Release H.4.1.
Sources: Board of Governors of the Federal Reserve System, Office of Financial Research
20 OFR ANNUAL REPORT TO CONGRESS 2020 FINANCIAL STABILITY or broadly, to include the This channel is crucial AND ECONOMIC central banks and all the for empowering financial government agencies that services to advance OPPORTUNITY regulate, insure, guarantee, productive innovations, and and monitor financial risks. thus promote the economic The term “financial growth necessary to reliably stability” implies that a WHY IS FINANCIAL increase living standards financial system can provide STABILITY IMPORTANT? over time.4 its basic functions for the economy, even under stress Financial stability is HOW DOES THE from unexpected events, necessary for households, COVID-19 PANDEMIC without emergency central as well as businesses small THREATEN THAT bank and taxpayer support. and large, to build and STABILITY? These functions include, further their economic for example, reallocating opportunities. A deep and The COVID-19 pandemic funds from savers to broad body of research has threatened, and may borrowers and managing reveals considerable continue to do so for some payments and risk. Threats historical and contemporary time, both robust economic to stability can arise from evidence that the growth and the stability that vulnerabilities exposed coexistence of financial financial services can offer.5 by unexpected events, sector development and or shocks. Vulnerabilities economic opportunity The COVID-19 crisis struck can be cyclical, such as reflects more cause and without announcing itself 2 the potential for increased effect than coincidence. in advance, unlike some leverage and risk-taking The president of the Federal previous crises (for example, during times of low Reserve Bank of New the financial crisis of 2007- interest rates. Or they York went a step further, 09 and the savings and can be structural, such as characterizing financial loan crisis of the 1980s, the spread of defaults via stability as a “prerequisite both of which involved market interconnections. for sustainable economic mortgage finance).6 As the 3 Shocks can originate from growth.” International Monetary inside the financial system, Fund’s First Deputy such as when a large bank Financial development, Managing Director recently collapses, or from outside among other things, reminded an audience, the financial system, as with requires organizational the Fund’s 2020 forecast the pandemic of 2020, the leaders to effectively anticipated positive oil cartel embargo of the address information frictions economic growth in most 1970s, or major wars. (such as adverse selection countries. Instead, by and moral hazard) and other midyear, the Fund estimated The financial system can transaction cost hurdles that 90 percent of countries be conceived narrowly that can discourage capital would see negative growth.7 as the network of private from finding and engaging No official financial stability financial actors of all kinds, its most promising projects. report, as discussed above,
PART ONE: ASSESSING FINANCIAL RISKS IN A TURBULENT YEAR 21 addressed the potential for a pandemic to threaten Figure 11. Domestic Auto Production Stalled in April as financial stability. Plants Closed, Then Recovered (thousands of units) 250 Economic indicators on the eve of the 2020 crisis showed little if 200 any concern about a slowdown, let alone a sharp 150 economic contraction. For example, the U.S. civilian unemployment rate for 100 February 2020 dropped to a 50-year low of 3.5 50 percent. It spiked to 14.7 percent just two months later.8 The abrupt change 0 in automobile production Jan Feb Mar Apr May Jun Jul Aug 2020 2020 2020 2020 2020 2020 2020 2020 — an important component of U.S. manufacturing with Note: Data as of August 2020. U.S. passenger car production, seasonally strong economic multiplier adjusted. effects — illustrates the Sources: Bureau of Economic Analysis, Office of Financial Research remarkably sharp drop in Risk). These vulnerabilities, of instability, starting in the economic activity, followed and others, are discussed 1790s. Under Alexander by a recovery (see Figure later in this report. Hamilton’s banking plan 11). Where we go from here to finance economic depends on how the virus HOW HAVE PREVIOUS growth, the First Bank of evolves and how people the United States and the and governments react to CRISES THREATENED market for U.S. Treasury that evolution. FINANCIAL STABILITY bonds were established. AND ECONOMIC The COVID-19 crisis also Then speculative players heightened previously OPPORTUNITY? entered, fraud emerged, known vulnerabilities. borrowers defaulted, and The United States has Examples include the extent credit tightened. Hamilton experienced periodic of leveraged lending and organized a rescue in which economic and financial commercial real estate the government purchased system turmoil since exposures (see Part 2, its own securities, a key declaring its independence, Credit Risk), high-risk asset precedent for intervention. reflecting the circumstances prices (see Part 2, Market of the various times. Risk), and dependencies After the War of 1812, the among participants in country experienced the We consider a brief review funding markets (see Part “Era of Good Feelings.” of several notable episodes 2, Liquidity and Funding Credit expansion fueled
22 OFR ANNUAL REPORT TO CONGRESS 2020 growth, but ended with any future financial crises, by a lack of confidence in businesses and farms failing but it didn’t. issuers, which the Federal in the Panic of 1819. Reserve addressed by The onset of World War making the discount The financial crisis of 1837 I triggered the Global window available to a generated failures and Financial Panic of 1914, number of commercial depression running into the closed stock markets, banks. There was also a 1840s, including defaults including the New York commercial real estate on several U.S. states’ debt. Stock Exchange, and led lending crisis, the “Great The federal government to inflationary war finance. Inflation” emerged, New refused to bail out those In 1918, when the United York City spiraled toward states. States had entered in the bankruptcy, and a cartel war and was making loans of oil-producing countries Prosperous booms and to allied governments sent oil prices soaring and occasional busts marked the that would later default, it supply dwindling. development of the nation. was also battling a deadly The prosperity of the 1850s, influenza pandemic, which The financial instability of boosted by the California continued into 1919 with the 1980s saw multiple Gold Rush and a boom disastrous global impact. bubbles burst. Oil prices in railroad development, collapsed — among other ended with the Panic of In the wake of thousands casualties were all the 1857. of bank failures in the biggest banks in Texas. Great Depression, the Farmland prices dropped The Civil War was followed Federal Deposit Insurance and the Farm Credit by eight years of prosperity, Corporation (FDIC) was System, a government- until bank, business, and created in 1933 to promote sponsored enterprise, numerous railroad failures confidence that deposits in had to be bailed out. Less followed in the Panic of banks were safe. This halted developed countries, as 1873. runs on the banks, but at they were then called, the cost of serious moral defaulted on their loans The late 19th century hazard that emerged in the and ignited a global debt was a time of remarkable 1970s and 1980s. crisis. The savings and loan innovation and growth, industry collapsed, and its but included the Panic of In the post-World War government insurer, the 1893. The early 1900s were II years, there were two Federal Savings and Loan scarred by the Panic of decades of notable Insurance Corporation, 1907, which generated the generalized prosperity, itself became irreparably political will to address the in spite of gloomy 1940s insolvent and was bailed “banking problem,” leading forecasts of “secular out by taxpayers. In the to the creation of the stagnation.” But in the early 1990s, there was a Federal Reserve in 1913. 1970s financial instability commercial real estate The Federal Reserve System reappeared. There was a collapse. More than 1,000 was launched with the panic in the commercial commercial banks failed belief that it would prevent paper market brought on
PART ONE: ASSESSING FINANCIAL RISKS IN A TURBULENT YEAR 23 between 1982 and 1992. HOW CAN FINANCIAL Office supports the FSOC But the Great Inflation STABILITY BE through applied analysis and long-term research by ended and rapid economic MAINTAINED? growth returned, bringing in monitoring, analyzing, and what was later called “The A more reliably stable reporting on developments Great Moderation.” financial system is important in the financial system and for a more robust economy. their impact on systemic With the speculations of Unfortunately, however, risk. The OFR also develops the dot.com bubble of the business cycle management tools for measuring and 1990s and with the 2000s is fraught with complexities. monitoring risks. To that housing and commercial Strengthening the end, our Office’s work real estate bubbles and the reliability of a more stable gains information through 2007-2009 financial crisis, financial system can more frequent collaboration we are sufficiently familiar. consistently support the with subject matter necessary intermediation experts from the FSOC What conclusions can to turn financial claims into and its subcommittees. be drawn from this quick tangible resources for the The OFR directly supports review? On average, the real economy. the FSOC by collecting, story of the United States validating, and maintaining from its first days of liberty Our financial system can be data necessary to carry to now is an upward made more reliable through out its duties. The OFR plotline of productivity the identification and aggregates, edits, and with increases in standards mitigation of vulnerabilities makes data available for of living, wealth, health, that can lead to instability analysis and research, while education, and comfort. But during times of stress. safeguarding confidentiality this admirable trend has The OFR works through and security. The OFR also frequently been interrupted several channels to support works with regulators and by periods of financial America’s financial stability industry standards bodies instability. through its data resources to identify and develop and analytical expertise. standards that are critical Reliably stable financial to improving data quality. organizations and markets Research and data services The Office promotes the are critical for continually to the Financial Stability use of these standards to creating greater and more Oversight Council (FSOC) advance financial research widely shared economic and its members.The and monitoring. opportunity. The loss of life OFR principally serves and productivity, as well as the FSOC through close OFR monitors.The OFR associated uncertainty from coordination on identifying has developed a collection the COVID-19 crisis, proved and producing germane of risk monitoring tools capable of compromising research, analysis, and data made publicly available the ability of financial that can further insights through its website (www. markets and organizations into financial vulnerabilities financialresearch.gov). With to further economic and their mitigants. Our these monitoring tools, opportunity.
24 OFR ANNUAL REPORT TO CONGRESS 2020 users can get a snapshot Annual Report relies on of financial markets at conventional monitoring any given time, with the of vulnerabilities based goal of timely identifying on research and data signals of vulnerabilities. insights. But as this report’s The monitors increase introduction highlights, market transparency and none of the 30 prominent facilitate research on the 2019 financial stability financial system for financial reports mentioned the industry participants (see potential for financial Part 4, Data Products). instability from a pandemic. The Short-term Funding Even if someone may have Monitor, introduced in had remarkable insights to September 2020, presents such a vulnerability, that daily information about person may not have had these critical funding sufficient incentive to share markets, which are the those insights at a scale that core of liquidity and could have made a material maturity transformation difference. in the financial markets. Data presented include Markets in “information” or repo market information “predictions” have shown collected daily by the OFR. promise in addressing such The Bank Systemic Risk problems by encouraging Monitor, introduced in people who have superior February 2020, presents key information to share it measures for monitoring at consequential scale. systemic risks posed by Qualitatively related the largest banks. And markets already operate on our Office’sU.S. Money platforms such as the Iowa Market Fund Monitor tracks Electronic Markets (iem. the investment portfolios uiowa.edu) and Predict of money market funds. It (www.predictit.org). Finally, OFR’s Financial Developing such markets in Stress Index serves as the service of strengthening a daily market-based financial stability may snapshot of stress across also help reveal costly global financial markets. or otherwise hidden information that can play a Complementing research fundamental role in creating and monitors with insights systemic risks (see Part 3, from information markets. Exploration of Information The assessment in this Markets).
PART ONE: ASSESSING FINANCIAL RISKS IN A TURBULENT YEAR 25
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY
Significant downside risks and financial consequences, financial effects of the to financial stability persist the long-term effects of emergency actions taken. amid high uncertainty. In the economic damage Risk remains elevated in our assessment, the risks to from months of lockdown comparison with last year financial stability primarily and ongoing restrictions across most risk categories reflect uncertainty about (including the extent (see Summary of Risks.) the future course of the of credit losses and pandemic and its economic bankruptcies), and future
SUMMARY OF RISKS
Macroeconomic risk is high. The course of the pandemic remains uncertain, as does the shape and pace of economic recovery. Government interventions provide support, but could come at the cost of higher inflation.
Credit risk is high. Leverage is high among nonfinancial corporations. Some lenders to the commercial real estate, energy, and high-touch service sectors face potentially severe losses from borrower defaults and bankruptcies. Municipal governments have serious revenue shortfalls. Some sovereign borrowers may seek bondholder concessions.
Market risk is elevated. Although stress in March led to a sell-off, the financial system remained resilient with help from the Federal Reserve. However, a midyear return to elevated valuations for many risky assets could provide potential tinder for another round of market stress.
Liquidity and funding risks are moderate. Risks and funding costs rose with the market turmoil in March, but the Federal Reserve’s liquidity facilities and banks’ liquidity buffers helped conditions stabilize quickly. Codependence between large providers and users of short-term funding remains a key vulnerability.
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 29 Leverage in the financial system has been restrained since the last crisis. Leverage amplifies losses. Financial system leverage rose in the first quarter as bank lending expanded to support the economy, but fell for hedge funds and some other financial firms exiting certain trading or investment positions. As of midyear, financial system leverage stabilized at a comparatively low level. Low financial system leverage could reduce risk of financial firm insolvencies arising from amplified losses.
Insolvency and contagion risks appeared contained. Bank loan loss provisions have increased sharply with expected losses, while capital buffers already in place appear to provide an adequate cushion for unexpected losses by banks and insurers over the near term. No large financial firm failures, or chains of failures, were observed during March.
Cyber risk grows both in volume and sophistication. While financial sector investment in cybersecurity can further the resilience of financial networks and systems, escalating threats from a variety of bad actors, as well as those that can emerge from increased dependence on remote work as a result of the pandemic, could aggravate vulnerabilities. The development of quantum computing presents a longer-term risk.
Pandemics can be added to the list of additional financial stability risks. Natural disasters, the United Kingdom’s exit from the European Union, and the transition from LIBOR to an alternative reference rates remain potential sources of risk.
This year’s COVID-19 pandemic has affected all these risk categories. It has greatly heightened overall uncertainty. It first caused market, liquidity, and funding risks to increase sharply. Government interventions relieved stress in the financial sector, leaving credit risk as the primary source of potential lender insolvencies, either directly or via potential contagion. Credit risk, in turn, reflects fundamental sectoral vulnerabilities plus the current high level of macroeconomic risk.
MACROECONOMIC government response to the economy. Individuals RISK curtail public health risk. limited their activities Governments acted to in compliance with slow the spread of illness government orders and out Economic activity slowed by closing many business of fear — a huge demand dramatically due to the operations and limiting shock. The international COVID-19 pandemic others — effectively, a spread of the pandemic saw and the unprecedented huge supply shock to these shocks reverberate
30 OFR ANNUAL REPORT TO CONGRESS 2020 through the global supply percent. Reduced interest for the U.S. hotel industry chain and export activity. rates that the Federal was down 102 percent from They also appear to be Reserve put in place during a year earlier.11 Clothing changing the mix of the second half of 2019 sales fell 49 percent in production and jobs.9 provided a strong dose of March, and restaurant and stimulus for the housing bar sales dropped by almost Unprecedented policy sector. New home sales hit a third. responses involving hitherto highs not seen since before unimagined central bank the 2007-09 crisis. That In addition to its direct, expansion and fiscal helped drive up residential measurable impact on transfers helped support construction at an annual demand, the COVID-19 the economy, provide rate of almost 18 percent crisis disrupted supply financial resources to those for the first quarter. chains. Many U.S. harmed by the recession, companies rely on global and finance the losses and The first reported COVID-19 suppliers, particularly the gross domestic product fatality in the United States suppliers in China, as the (GDP) shrinkage as the came in February. Beginning latter contributed to 18 nation struggled to weather in March, the economy percent of all 2019 imports. the pandemic. deteriorated rapidly. The pandemic-driven Evidence came quickly from supply shock amplified Signs of improvement industries that had people the drop in demand, as became evident by in close proximity and more businesses sought to find midyear, with considerable vulnerable to the spread new trading partners and monetary and fiscal of the virus. Occupancy at to alter products. More stimulus facilitating a U.S. hotels, as an example generally, U.S. firms depend bridge to economic of a vulnerable industry, on trade with parts of China recovery. Macroeconomic fell from 62 percent for the affected by the pandemic. risk, nevertheless, appears week ended March 7 to 30 Some studies suggest that unusually high in light of percent for the week ended more than 15 percent of deep uncertainty about the March 23.10 Conferences Fortune 1000 companies pandemic’s course. and group events were have Tier 1 suppliers — cancelled across the nation. companies that directly U.S. ECONOMIC Restaurant and movie sell them products — in CONDITIONS theater business collapsed a virus-affected Chinese over the same weeks (see region. Ninety percent have The U.S. economy showed Figure 12). That was all a Tier 2 supplier, one step considerable strength before the last two weeks further away in the supply through the first two of March, when most states chain.12 These linkages months of 2020. February’s severely restricted business contributed to a significant employment report saw and individual activities to drop in trade. In February, 273,000 jobs created contain the pandemic. For when China was struggling and a remarkably low March as a whole, general with the virus, U.S. imports unemployment rate of 3.5 operating profit per room of select products from
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 31 China (textiles, apparel, March, the number of shrank 1.3 percent in computers, and others) nonfarm payroll employees the first quarter, or an dropped more than 10 shrank by 1.4 million, annualized rate of 5 percent compared with a followed by a historic percent, and 9 percent in year earlier.13 drop of 20.8 million in the second quarter, or an April.14 As a result, what annualized 31.4 percent, Unemployment quickly had been a 50-year low the steepest quarterly drop followed in the wake unemployment rate in in records dating back to of these disruptions to February was replaced in 1947. Standards for many demand and supply. In April with a rate not seen types of credit tightened since the Great Depression in those periods. This Figure 12. Social Distancing (see Figure 13). The 14.7 tightening helped limit Shut Down Movie Theaters percent unemployment rate credit risk for lenders as and Restaurants (year-over- far surpassed the previous the quality of their existing year percent change) post-World War II high of credit deteriorated, but 10.8 percent in late 1982. also made it harder for 40 Domestic movie households and businesses theater box Amid these conditions, to cushion the impact of of ce receipts the U.S. economy entered 20 the slowdown. While the Reservations for a steep recession.15 It restaurant seating 0 Figure 13. U.S. Unemployment Rate Since 1929 (percent)
-20 30
-40 25
-60 20
-80 15
-100 10 Jan Mar May Jul Sep 2020 2020 2020 2020 2020 5 Note: Reservations measured as seated diners on the OpenTable Network: online reservations, phone 0 reservations, and walk-ins. Changes 1929 1942 1955 1968 1981 1994 2007 2020 to gross box office receipts and reservations compare the same day of Note: Data from 1929-39 were developed by the Bureau of Labor Statistics, but the week from year to year. do not come from the Current Population Survey (CPS), the household survey that is the source of the data beginning in 1940. The monthly series begins in Sources: OpenTable, Box Office Mojo, Office of Financial Research 1948; data prior to 1948 are annual.
Sources: Bureau of Labor Statistics, Office of Financial Research
32 OFR ANNUAL REPORT TO CONGRESS 2020 Figure 14. Government Monetary and Fiscal Policy Actions Addressed Pandemic Effects ($ trillions)
Legislative actions
Federal Reserve asset purchases
Federal Reserve emergency lending
Federal Reserve liquidity measures Funds committed/disbursed Funds allowed Administrative actions
0 1 2 3 4 5
Note: Funds allowed include disbursed amounts for programs with no announced size limits.
Sources: Committee for a Responsible Federal Budget, Office of Financial Research March-April downturn was showed that employers decline. These are quarterly, rapid, extraordinary support started to hire again, not annualized changes. from monetary and fiscal notably in sectors strongly This pattern of collapse policy helped to mitigate affected by the pandemic. and then recovery dwarfs the damage over the short- The leisure and hospitality the quarterly moves of the to-medium run (see Figure industries, for example, 2007-09 crisis (see Figure 14). That support also accounted for more than 35 15). sent the federal budget percent of new employment deficit to a record high. gains over that period. With residential mortgage Fiscal year (FY) 2020’s $3.1 All told, by the end of rates at historic lows, partly trillion deficit easily beat September, 51.5 percent due to accommodative the previous record of $1.4 of jobs lost in March and monetary policy, home sales trillion for FY 2009. Further, April had been restored. and mortgage refinancing when expressed in terms The unemployment rate have rebounded. Indicators of the value of the dollar slowly declined from its of retail sales and other today, the FY 2020 deficit April high of 14.7 percent economic activity in the outpaces the FY 2009 to 7.9 percent by the end third quarter were also deficit by $1.4 trillion. of September. Although consistent with a return to much improved, the economic growth. Amid this Economic activity bottomed unemployment rate as of environment, with reduced in the second quarter, as September was still high. consumer demand, steps mobility picked up and to reconfigure business governments started to lift The third quarter saw a models and improve health restrictions. Jobs reports sharp rebound in real GDP and safety standards raised discussing activity from of 7.4 percent following the business costs. In line with May through September second quarter’s 9 percent the slowing pace of job
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 33 growth, the initial rise in consumer spending for Figure 15. U.S. Real GDP Change from Prior Quarter, Not May gradually reduced to 1 Annualized (percent) percent month-over-month 10 growth in August. Positive growth 8 Against this backdrop, Negative growth economic risks to U.S. 6 financial stability continue 4 to be unusually high. Deep 2 uncertainty remains about the course of the pandemic. 0 As long as that is the case -2 and most of the population Financial remains vulnerable to -4 crisis the virus, the pandemic -6 and actions to control it -8 will continue to elevate macroeconomic risk. Efforts -10 to avoid and contain the 2008 2010 2012 2014 2016 2018 2020 virus could continue to put pressure on economic Note: GDP stands for gross domestic product. activity and incomes. The Sources: Bureau of Economic Analysis, Haver Analytics, Office of Financial Research ability of households and partners, as uncertainty 2021.16 To the extent that businesses to manage over trade tensions and these expectations are liabilities could, in turn, be the United Kingdom’s realized, net growth could reduced. Credit risk grows in exit from the European be negligible over the two turn (see Credit Risk), with Union (EU) took hold. The years. the possibility of numerous fourth quarter of 2019, for defaults and bankruptcies. example, saw Japan’s real China, where the virus Household and business GDP fall 7.2 percent on originated, was the first insolvencies feed back into an annualized basis, while country to lock down. The macroeconomic risk, making growth in the eurozone virus spread quickly, and the financial system more slowed to its lowest rate the consequent shock vulnerable to instability. in seven years. These to economic activity was conditions left economies followed by a 6.8 percent GLOBAL ECONOMIC and financial systems more contraction in the first CONDITIONS vulnerable to distress quarter over a year earlier, from any shock. Given the its first such published Global economic conditions pandemic, the International negative growth rate since created headwinds for the Monetary Fund (IMF) at least 1992.17 China United States’ economy expects global growth to reported a return to growth going into 2020. Growth contract 4.4 percent in 2020 in the second quarter. slowed in major U.S. trading and expand 5.2 percent in However, the initial shock
34 OFR ANNUAL REPORT TO CONGRESS 2020 created ripple effects or at an annualized rate second-largest of China. A elsewhere, disrupting of 14.9 percent. Second potentially slow recovery in supply chains and further quarter European growth China, or a deeper or more weakening economies slowed even more, the protracted downturn in globally, beyond the biggest drops since the EU Europe, could weaken the effects of low demand and was established in 1995.18 outlook for global trade and shutdown measures (see While an improvement is increase macroeconomic Figure 16). widely expected in the third risk to the United States. In the first quarter of quarter of 2020, economic Similarly, a weak recovery 2020, Japan and two of indicators suggest a slow in emerging market nations Europe’s largest economies, recovery. Continued that engage in substantial France and Italy, posted declines in consumer trade with the United their second consecutive and business sentiment States could pose further quarters of negative growth, in Europe are leading downside risk for U.S. placing them in a technical indicators of weak future corporations. For example, recession. For the eurozone demand. Brazil, Mexico, India, and as a whole, GDP growth Vietnam were all among the The European Union is contracted 3.7 percent, top trading partners for the the top trading partner of the largest quarter-on- United States in 2019. the United States and the quarter decline on record,
Figure 16. Growth in Major Economies (percent change from previous year)
7
2
-3
-8 Japan Germany -13 France Canada -18 United Kingdom
-23
-28 Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Note: Data as of June 30, 2020. Real gross domestic product, percent change from corresponding quarter of previous year, seasonally adjusted. Some data are preliminary and subject to revision. Shaded areas are U.S. recessions.
Sources: OECD Main Economic Indicators, Office of Financial Research
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 35 POLICY RESPONSES reduced and maintained cash transfers to individuals, their key short-term funding enhanced unemployment Macroeconomic policy rates close to zero, or in insurance benefits, and responses to the COVID-19 some cases less than zero. brought tax relief to support economic crisis were With interest rates close to household cash flows and extraordinary by historical their lower bounds, central avoid defaults on consumer measure. When financial banks accelerated asset credit.19 The Coronavirus market disruptions came purchases, and at a pace Aid, Relief, and Economic to the United States, the faster than during the 2007- Security Act (CARES Act) Federal Open Market 09 crisis. The ECB launched mandated that certain loans Committee further eased and later extended a in forbearance could not monetary policy. In the pandemic-focused program be reported as delinquent, first half of March, the to purchase eurozone even though not paying. committee brought its government and corporate policy rate to a range of 0 debt. This official bid helped Authorized U.S. fiscal to 0.25 percent. Between reduce risk premiums on relief through May totaled March and the end of June, European sovereign and almost $4 trillion. The fiscal the Federal Reserve added corporate debt. The ECB’s packages rapidly expanded $2.8 trillion to its balance other stimulus measures central government sheet, equivalent to 14 included a lower, negative borrowing as a share of percent of GDP. Lower interest rate on loans to GDP, well beyond the high policy rates and Federal banks and acceptance of levels seen in 2019 (see Reserve asset buying quickly non-investment grade, or Figure 17). Federal debt restored financial market junk, bonds as collateral held by the public reached functioning and supported for loans. Like the Federal $21 trillion in FY 2020, or asset prices. In particular, Reserve, the Bank of Japan an estimated 99 percent of equity prices as measured pledged to purchase GDP at the end of FY 2020. by the S&P 500 index, which unlimited government debt, had fallen by 34 percent while the Bank of England It remains to be seen what from February 19 to its started its own program to path the U.S. economy bottom on March 23, had buy corporate bonds and may take on the way to recovered all of their losses U.K. government bonds. recovery, which remains a by August. major risk to U.S. financial On the fiscal front, relief stability. Many households Central banks from other packages in the United and businesses have advanced economies States and elsewhere not recovered even with similarly provided very included loan programs, government support. large monetary stimulus to guarantees, debt cushion the contraction. forbearance, and wage Core inflation remains For example, the European subsidies to help firms below the Federal Reserve’s Central Bank (ECB), Bank avoid bankruptcy and objective of a continuous of Japan, Bank of England, maintain jobs. They funded 2 percent, although the and Bank of Canada all targeted and untargeted consumer price index rose in June and July at
36 OFR ANNUAL REPORT TO CONGRESS 2020 Figure 17. General Government Deficit, Actual and Forecast (percent of gross domestic product)
24 2017 2018 20 2019 16 2020 2021 12
8
4
0
-4 Canada China France Germany Italy Japan United United Kingdom States
Note: The general government deficit is defined as the fiscal position of central, state, and local governments after accounting for capital expenditures. Forecasts start after 2019 for Canada, China, France, Germany, Italy, United Kingdom, and United States. Forecasts start after 2018 for Japan. Negative values indicate surplus.
Sources: International Monetary Fund World Economic Outlook Database, October 2020, Office of Financial Research 0.6 percent per month, two channels through which otherwise profitable and for an annualized rate of uncertainty affects business welfare-improving projects 7 percent.20 As the size of decisions. First, uncertainty due to the increased cost of fiscal programs increase, motivates corporations financing. the growing federal debt to delay investment and could remain a long-term hiring as they wait for more The spread of the COVID-19 risk. On the other hand, information before starting pandemic to the United many households and projects with lower marginal States and the shutdown businesses may be unable returns or high sunk costs.21 of the U.S. economy in to recover absent additional Second, uncertainty March was a shock so severe government support. regarding the success of that the effects exceeded a corporate venture tends the extremely adverse UNCERTAINTY PREVAILS to increase the cost of scenario used in the Federal financing because banks Reserve’s bank stress tests.23 Uncertainty amplifies both and debt investors demand Due to the novelty of the economic and financial a higher return for the virus, the unknowns of its system shocks. Studies that additional risk associated course and the response link uncertainty to weaker with such ventures.22 of health policy, many economic growth emphasize Firms might not invest in businesses are unsure when
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 37 or even if they will resume normal operations and what Figure 18. Business Uncertainty Rose with the Pandemic new safeguards they must (index) erect. Considerations like 6 these have contributed to an environment of high uncertainty for businesses 4 (see Figure 18). Because uncertainty remains high about the 2 pandemic’s course, as well as the pace and efficiency of business reopenings, the 0 range of plausible future Sep Sep Sep Sep Sep outcomes may be wide. 2016 2017 2018 2019 2020 Such uncertainty can weigh heavily on economic activity. Note: The Business Uncertainty index is based on Altig, Barrero, Bloom, Davis, Meyer, and Parker (2020). This index reflects a survey of firms’ uncertainty as measured by the sales-weighted average standard deviation of the probability CREDIT RISK distributions of each of the firms’ own next-four-quarter sales expectations. Sources: Altig and others (2020), Atlanta Fed/Chicago Booth/Stanford Survey of Business Uncertainty, Office of Financial Research The risk that numerous borrowers or counterparties U.S. corporate leverage was commute, add to this year’s might not meet their already high entering into stress and uncertainty about financial obligations 2020, especially among the severity of potential remains elevated. The companies with credit losses. financial effects of the ratings below investment COVID-19 pandemic and grade. Those same Household credit risk, in recession have moved companies may now face contrast, was relatively through businesses, operating challenges as low at the beginning of households, and all levels the ability to service debt the year. This risk has of government. Direct or take on additional debt risen along with record government payments to declines. unemployment and growing households and businesses numbers of business have partially mitigated As has been the case in past bankruptcies. Even with default risk. Banks tightened financial crises, commercial forbearance on mortgages lending standards for all real estate (CRE) is expected and other bills, continued loan types in the first and to be a prime source of uncertainty about the pace second quarters.24 While this potential credit problems. of job recovery can increase reaction can be expected, Changes in business models vulnerabilities to the ability the resulting reduction in and consumer behavior, of households to keep up loan availability could hinder such as continuing to with loan payments. The economic recovery. work at home for fear of delinquency rate on one-to- infection in the office or on a four family mortgages rose
38 OFR ANNUAL REPORT TO CONGRESS 2020 to a seasonally adjusted years of exceptionally low U.S. nonfinancial index 8.22 percent at the end of interest rates and strong was rated BBB, the lowest second quarter 2020, up investor appetite for yield. rated category within 3.86 percentage points from The COVID-19 pandemic investment grade. Within first quarter 2020 and 3.69 came as a severe shock. BBB, $824 billion, or 27 percentage points from a The policy response in percent, was rated BBB- year earlier.25 March ensured that many (just one notch above high corporations were able to yield). This cohort is most State and local governments obtain funding via capital susceptible to downgrades have seen sharp drops in markets. However, defaults to high yield. A wave of revenue, while needs for and downgrades can still downgrades could disrupt resources to cope with the threaten market stability financial markets because pandemic have increased. and the solvency of some some pension funds and As a result, default risk has lenders with loan portfolios other institutional investors risen for some municipal concentrated in troubled have strict mandates to hold bonds, especially those sectors. Implications differ only investment-grade rated backed by revenue streams between investment-grade securities. These investors from projects such as transit debt and non-investment could be incentivized to sell systems and convention grade debt, also known as debt downgraded to below centers. high-yield or junk debt. By investment grade. definition, high-yield debt Internationally, the global has a higher probability of To date, however, credit pandemic increased default, as reflected in lower markets have absorbed the stress on some foreign credit ratings. Implications record level of fallen angel government debt. Argentina also vary by business sector debt (see Figure 19). As of defaulted on its debt in within those two categories. September, fallen angels May, its ninth sovereign That is, some sectors are (issues removed from the default. Several other more highly leveraged and ICE BofA U.S. corporate countries, including some exposed to the economic index) totaled $250 billion, large ones such as Italy, shutdown that accompanied significantly exceeding have seen default risks the pandemic. annual levels over all rise. International support prior years. Of this total, through organizations Investment-grade debt. $170 billion transitioned such as the International The primary financial into the high-yield index Monetary Fund may provide stability risk from (some fallen angels are support for sovereign debt investment-grade debt is not eligible for inclusion in crises. credit rating downgrades the U.S. high-yield index), to high-yield status, or representing 14 percent NONFINANCIAL so-called fallen angels. of the index’s face value CORPORATE CREDIT As of September, $3.0 as of the end of 2019. In trillion of the $5.2 trillion in comparison, from 2011 High corporate leverage investment-grade corporate through 2019, fallen angel has been encouraged by bonds in the ICE BofA debt (trailing 12 months)
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 39 averaged 3 percent of the Figure 19. Fallen Angel Debt ($ billions, trailing three- face value of the high-yield month total) index. 250 COVID-19 Before the COVID-19 crisis, BBB-rated companies had 200 several effective avenues to boost cash flow for ‘07-’09 150 Oil price debt service and maintain nancial Telecom collapse their investment-grade GM, crisis 100 meltdown status. These avenues Ford included asset sales or reductions in dividends, 50 share buybacks, and capital 0 spending. Now, earnings Mar Mar Mar Mar Mar Mar have declined materially 2000 2004 2008 2012 2016 2020 for many companies, eroding their ability to Note: Includes financial issuers. Fallen angels are issuers downgraded from service debt. Despite the investment grade to high yield; fallen angels above refer to issuers previously included in the BofA U.S. Corporate Index (C0A0). decline in earnings year to date, investment-grade Sources: BofA Global Research, ICE Data Services, Office of Financial Research issuance is at record highs and corporations have Figure 20. Median Leverage and Interest Coverage for drawn from revolving credit BBB-rated Companies (ratios) facilities. As a result, credit 3.5 8 quality has weakened as leverage ratios (gross debt 3.0 to earnings before interest, 6 2.5 taxes, depreciation, and amortization (EBITDA)) have 2.0 risen and interest coverage 4 1.5 ratios (earnings before interest and taxes (EBIT)) 1.0 Leverage ratio (left axis) 2 to interest expense) have declined (see Figure 20). 0.5 Interest coverage ratio (right axis)
0.0 0 Non-investment grade Jun Jun Jun Jun Jun Jun Jun debt. Key concerns for 1990 1995 2000 2005 2010 2015 2020 high-yield and unrated companies are whether Note: Data as of June 30, 2020. Leverage is defined as gross debt-to-EBITDA they are able to refinance (earnings before interest, taxes, depreciation, and amortization). Coverage is defined as EBIT-to-interest expense. Ratios are four-quarter moving averages. debt or service existing debt. To date, an increasing Sources: Compustat, Office of Financial Research number of companies
40 OFR ANNUAL REPORT TO CONGRESS 2020 have been unable to became law on March 27, sharp decline in earnings adequately service their market sentiment improved (see Figure 21). The ability debt obligations, which dramatically. The perceived of firms to make interest triggered a rise in defaults risk of a disruption to credit payments on their debt has and bankruptcies. Defaults, availability is substantially remained robust due to low in turn, could lead to lower. However, businesses interest rates, but interest credit losses for bank and with unsustainable business coverage ratios are falling nonbank lenders. Those models and high debt as earnings decline. lenders with insufficient burdens may have trouble Credit spreads reflect the loss-absorbing capacity refinancing existing debt, stress in borrowing markets. would need to sell as evidenced by the recent During March, the index- assets or raise capital to increase in bankruptcy level high-yield corporate maintain solvency. Federal filings. bond spread increased from Reserve lending programs below average to more are largely targeted Leverage ratios are likely than 1,000 basis points. at investment-grade to exceed the 1999 all-time Spreads exceeding 1,000 companies, but also include median peak of 5.2 times basis points, or 10 percent, certain high-yield firms. EBITDA this year given the
The U.S. leveraged finance Figure 21. Median Leverage and Interest Coverage for market, including high- High-yield Companies (ratios) yield bonds and leveraged loans, was $3.6 trillion in 6 5 size in 2019, or almost 31 Record 5.2x in 1999 percent of nonfinancial 26 4 corporate debt. Many of 5 these borrowers are either not covered by government 3 lending programs — for 4 example, because of poor credit quality — or 2 coverage is insufficient relative to financing needs. 3 Debt-to-EBITDA (left axis) 1 In March, credit spreads Interest coverage: EBITDA (right axis) Interest coverage: EBIT (right axis) rose rapidly to distressed 2 0 levels, issuance of new high-yield debt froze, Jun Jun Jun Jun Jun Jun Jun 1990 1995 2000 2005 2010 2015 2020 and secondary market liquidity deteriorated. Note: Data as of June 30, 2020. Shaded areas are U.S. recessions. Leverage is gross debt-to-EBITDA (earnings before interest, taxes, depreciation, and After the Federal Reserve amortization). Coverage is EBITDA and EBIT divided by interest expense. introduced its market Leverage and coverage are four-quarter moving averages of the median. support programs on March Sources: Compustat, Haver Analytics, Office of Financial Research 23 and the CARES Act
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 41 are generally associated with distress by market Figure 22. U.S. Corporate Bond High-yield Default Rate participants. Historically, vs. Credit Spread (percent, basis points) very sharp increases in 16 2,500 spreads precede higher Default rate, percent (left axis) defaults and economic 2,000 recessions (see Figure 22). 12 Credit spread, basis points (right axis) Lower-rated non-investment 1,500 grade issuers are at higher 8 risk of default. Corporate 1,000 bonds rated the equivalent of B- and lower totaled 4 $303 billion, or 23 percent 500 of the ICE BofAML U.S. high-yield nonfinancial 0 0 index as of September. 2000 2004 2008 2012 2016 2020 Institutional leveraged loans rated B- and lower Note: Shaded areas are U.S. recessions. Credit spread is monthly average (daily totaled almost $392 billion, peak exceeded 1,000 basis points in March). Defaults reflect high-yield bonds (excludes loans). or 32 percent of the S&P/ LSTA Leveraged Loan Sources: Moody’s Investors Service, Haver Analytics, Office of Financial Research Index. Thus, across bonds debt funds and business Default risk is higher for and loans, debt rated development companies, in highly leveraged companies B- or lower approaches aggregate are larger than that need to roll over $700 billion. However, this the $1.2 trillion institutional maturing debt. Heading estimate may understate leveraged loan market. into the crisis, high-yield the total debt at risk Some corporate borrowers bonds maturing in 2020 because it excludes pro benefit from the Federal through 2022 totaled $630 rata leveraged loans and Reserve’s Main Street billion, or 59 percent of leveraged loans originated lending facilities, but many total high-yield bonds by private debt funds and highly leveraged borrowers outstanding (see Figure business development are not eligible. These 23). The maturity wall for companies. Assessing the borrowers face higher leveraged loans was not amount of debt at risk in default risk or much higher as steep. Only 8 percent these segments is difficult financing costs. Further, of these loans mature over due to data limitations. As adding new debt onto the the same period. However, highlighted in the OFR’s already highly leveraged if borrowers default on 2019 Annual Report, bank- balance sheets of these interest payments or if they held leveraged loans and companies is not a viable trip cross-default provisions, middle-market leveraged strategy. Some of these creditors could accelerate loans, the latter of which companies may need new debt repayments. Maturity are originated by private equity capital to survive. walls have shifted since the
42 OFR ANNUAL REPORT TO CONGRESS 2020 spring, as many companies This default cycle will in the oil and gas and refinanced debt, pushing encompass a much broader the metals and mining out maturities. range of industries than industries. As of second during 2015-16, when quarter 2020, every sector defaults were concentrated had a higher share of firms with very high leverage Figure 23. Maturities by Year for High-yield Bonds (top) as compared with the and Leveraged Loans (bottom) ($ billions, percent) median share since 1990 350 30 (see Figure 24). Very high Maturities $ billions (left) leverage is associated with Percent of total (right) 300 25 debt levels that exceed six times EBITDA. Similarly, 250 20 the share of companies 200 with low interest coverage 15 ratios is high (see Figure 150 25). Interest coverage 10 ratios below 1, meaning 100 interest expenses are more 50 5 than EBIT for the same period, are considered 0 0 unsustainable over the 2020 2021 2022 2023 2024 2025 2026 2027 2028+ long term. The share of companies in this cohort Note: Maturities as of March 2020. will increase because Sources: Dealogic, Office of Financial Research coverage ratios are likely to deteriorate further.
350 30 Corporate defaults have Maturities $ billions (left) risen in 2020 as lower- 300 Percent of total (right) 25 quality borrowers struggle 250 to meet their financial 20 obligations. Through 200 August, corporate defaults 15 150 on U.S. bonds and loans totaled $134 billion, the 10 100 highest year-to-date total since 2009 (see Figure 5 50 26). The trailing 12-month 0 0 default rate for high-yield bonds and loans stood 2020 2021 2022 2023 2024 2025 2026 2027 2028 at 8.4 percent in August, Note: Maturities as of March 2020. Includes financial sectors (6 percent of up from 4.5 percent in outstanding loans). February.27 For comparison, Sources: S&P Leveraged Commentary and Data, Office of Financial Research
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 43 the default rate average Figure 24. Firms with Leverage Ratios Exceeding 6x for the high-yield sector (percent of firms in sector) since 1987 is 4.7 percent, with a peak default rate Total of 14.7 percent in 2009. Health care Moody’s Investors Service Communications estimates that default Consumer discretionary rates will reach double digits in several industries, Energy including automotive; Technology business services; consumer Consumer staples goods; consumer services; Utilities hotel; gaming and leisure; and wholesale.28 In total, Materials Q2 2020 Moody’s forecasts that Industrials Median 1990-2019 defaults will reach 11.4 0 10 3020 40 50 60 70 percent in the first quarter of 2021.29 Note: Data as of June 30, 2020. Includes high-yield and unrated firms. Leverage is gross debt-to-EBITDA (earnings before interest, taxes, depreciation, and As default rates rise, the amortization). number of bankruptcies Sources: Compustat, Office of Financial Research will rise, too. Through September, Chapter 11 Figure 25. Firms with Interest Coverage Below 1x (percent bankruptcy filings by of firms in sector) businesses exceed 5,500, up from approximately 4,150 Total for the comparable period Energy a year earlier.30 However, Health care part of the increase may be due to a change in the law Communications in February making it easier Consumer discretionary for small companies to file Consumer staples for Chapter 11. Annual Technology Chapter 11 filings exceeded Materials 13,600 in 2009 during the depths of the previous Industrials Q2 2020 financial crisis. There are Utilities Median 1990-2019 at least two key concerns with regard to a large wave 0 10 3020 40 50 60 70 of bankruptcy filings. First, Note: Data as of June 30, 2020. Includes high-yield and unrated firms. Interest this could overwhelm the coverage is earnings before interest and taxes (EBIT) divided by interest bankruptcy system, resulting expense. in congested courts and an Sources: Compustat, Office of Financial Research
44 OFR ANNUAL REPORT TO CONGRESS 2020 has also rebounded from Figure 26. U.S. Corporate Bond and Loan Defaults ($ its low point in March. billions) Through September, year- 1,200 to-date leveraged loan Rest of year issuance totaled $300 Year-to-date August billion, down 20 percent 1,000 from the comparable period a year ago. The decline in 800 leveraged loan issuance is in part due to issuers 600 turning to bond markets for funding and to lower 400 merger and acquisition activity. Overall, bond and loan issuance has enabled 200 some firms to pay down 0 revolving credit lines that 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 were drawn on earlier in this crisis, to build cash reserves, or to refinance Note: Data for 2020 as of August 31. Includes financial sectors. existing debt (thereby Sources: Moody’s Investors Service, Office of Financial Research pushing out maturity walls as noted earlier) at lower inability of filers to obtain Corporate debt issuance. rates. But in aggregate this critical debtor-in-possession In March, corporate bond borrowing also increases financing.31 Second, and loan issuance stalled. already-high leverage. many of these Chapter Issuance of corporate bonds 11 reorganizations may rebounded significantly Collateralized loan ultimately become business in April following the obligations (CLOs). CLOs liquidations. Liquidations government interventions are a structured finance could result in larger introduced in late March product that primarily realized losses for creditors. and early April. Investment- hold leveraged loans Liquidations could also have grade nonfinancial issuance as part of a collateral a greater negative impact set new monthly records pool that generates cash on the economy via layoffs in March ($195 billion) flows for investors. At and reductions in capital and April (more than $230 the end of 2019, there spending at the businesses billion). As of September, were $686 billion in U.S. being liquidated. Large year-to-date investment- CLOs outstanding, up losses by creditors would grade issuance is a record- 16 percent from 2018. in turn result in a further high $1.1 trillion (see Following the disruption in tightening of financial Figure 27). High-yield the CLO market in March, conditions, constraining issuance surged as well as the issuance of new CLOs credit to higher quality risk sentiment improved. declined. At midyear, there businesses. Leveraged loan issuance
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 45 the tranche’s position in Figure 27. U.S. Nonfinancial Corporate Bond Issuance the capital structure along ($ billions) with the credit quality of the 1,200 underlying collateral. The High yield CLO manager and contract 1,000 Investment grade terms also affect the rating. CLO investors include 800 banks, insurance companies, investment managers, and 600 pension funds. Ninety- five percent of bank CLO 400 holdings are rated AAA, and CLOs are 5 to 7 percent of 200 bank securities portfolios, on average. However, many 0
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 smaller banks do not hold any CLOs. AAA-rated CLO tranches have not defaulted
Note: 2020 represents issuance through September. Prior years are full-year in the 30-year history of issuance. Investment-grade issuance includes preferred shares. this product. Insurance
Sources: Dealogic, Office of Financial Research companies and others hold varying tranches of the CLO were $707 billion in CLOs receive payments after all market. outstanding.32 payments have been made to all other tranches. The Stress tests by the National A CLO is divided into tranches in between the Association of Insurance tranches, each with a AA-rated and the below- Commissioners and the specified right to receive investment grade “junior” ratings agencies indicate payments resulting from (nonequity) tranches are that the failure of an AAA- the underlying investments’ known as mezzanine rated CLO is unlikely.33 cash flows. The most senior- tranches. Similar to the most There is greater risk of rated tranche is initially senior-rated tranche, the default for CLO tranches rated AAA and typically mezzanine tranches typically rated below AAA. For now, pays a floating interest rate pay an interest rate tied to other CLO tranches that tied to a spread over a a spread over a reference are rated investment grade reference rate (historically rate, the same reference have sufficient support to LIBOR, see Additional rate used for the most keep making payments Risks). The AAA-rated debt senior-rated tranche. The despite underlying collateral tranche typically accounts spread reflects the credit defaults, losses, and rating for about 64 percent of a risk of the tranche, and each downgrades. However, a CLO’s total capital structure. mezzanine tranche can be protracted pandemic and Investors in the most junior separately rated. The rating corresponding economic tranche, the equity tranche, is determined, in part, by slowdown could affect these
46 OFR ANNUAL REPORT TO CONGRESS 2020 payouts. About 67 percent of CLOs have exposure to Figure 28. Commercial Real Estate Valuations Swing with industries hit hardest by the Economic Conditions (index) pandemic, including the 250 travel and leisure, retail, automotive, oil and gas, and 200 airline industries.
COMMERCIAL REAL 150 ESTATE 100 The commercial real estate market is often 50 subject to volatile swings during economic cycles (see Figure 28). During 0 favorable economic 1970 1980 1990 2000 2010 2020 periods as demand for CRE Note: National Association of Real Estate Investment Trusts Composite Price assets increases, rents and Index tracks prices of real estate investment trust (REIT) stocks; the index equals market values rise, loan- 100 in December 1971. Shaded areas indicate U.S. recessions. to-value (LTV) and debt Sources: National Association of Real Estate Investment Trusts, Office of Financial Research
Figure 29. Commercial Real Estate Debt as a Percent of Gross Domestic Product ($ trillions, percent)
6 30 Total commercial real estate debt as a percent of GDP (right axis) 5 25
4 20 Construction and development loans 3 ($ trillions, left axis) 15 Multifamily mortgages ($ trillions, left axis) 2 Commercial mortgages ($ trillions, left axis) 10
1 5
0 0 1984 1989 1994 1999 2004 2009 2014 2019
Note: Data as of June 30, 2020. Commercial mortgage data as reported on Federal Reserve System’s Release Z.1 exclude construction and development (C&D) loans. C&D loans as reported on FDIC Call Reports. Total commercial real estate debt is the sum of the three categories shown.
Sources: Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Haver Analytics, Office of Financial Research
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 47 service coverage ratios holding half of the debt Among the other banks, look strong, default rates outstanding (see Figure 30). CRE loans rose from 6 and credit losses are low, CRE represents 22.4 percent percent to 11 percent.34 At and debt increases. During of the banking industry’s the time, large banks were unfavorable economic loans and leases, with the significant CRE lenders. The periods such as the current highest share among banks Government Accountability COVID-19 driven downturn, with $1 billion to $10 billion Office in 2013 reported the reverse is typically in assets (see Figure 31). that from 2008 to 2011, true. In many cases, rents failures of small and and market values decline, CRE credit problems medium-size banks were and LTV and debt service have been a major cause largely associated with ratios rapidly reach levels of depository institution high concentrations of where risk of loan defaults failures. Between 1980 and commercial property rise, often resulting in large 1993, the concentrations loans.35 The scale of bank losses. This high degree of CRE loans relative to CRE losses and their of economic sensitivity is total assets were higher for impact has moderated increasingly important as banks that subsequently due to improved capital CRE debt rises from its low failed than for surviving positions and increased after the 2007-09 financial banks. For failed banks, CRE asset diversification, but crisis (see Figure 29). loans rose from 6 percent bank losses due to high to almost 30 percent of CRE exposures will likely CRE leverage exacerbates total assets over 1980-93. continue to be a concern. the cyclical sensitivity. CRE leverage can be secured, Figure 30. Funders of Outstanding Commercial Real such as a mortgage on Estate Debt (percent) a specific property, or unsecured, such as a bond 100 Other investors issued by a real estate REITs 80 investment trust (REIT). By Other asset-backed making the loan, the lender, 60 issuers including CMBS possibly leveraged itself, GSEs and agency-backed indirectly assumes downside 40 mortgage pools risk similar to that assumed Insurance companies by the property owner. 20 Depository institutions
Lenders. Much CRE funding 0 is supplied by regulated 1980 1990 2000 2010 2020 financial institutions, particularly banks, other Note: Data as of June 30, 2020. REIT stands for real estate investment trust. CMBS stands for commercial mortgage-backed securities. GSE stands for depository institutions, and government-sponsored enterprise. Excludes construction and development insurers. Banks and other loans held by banks. Other investors include pension plans, finance companies, depository institutions have households, and nonfinancial businesses. historically extended the Sources: Board of Governors of the Federal Reserve System, Haver Analytics, Office of Financial Research largest share of CRE loans,
48 OFR ANNUAL REPORT TO CONGRESS 2020 Figure 31. Bank Exposure to Commercial Real Estate by Real Estate Type ($ billions, percent)
Institution size More than $10 billion to $1 billion to Less than by total assets $250 billion $250 billion $10 billion $1 billion Total
Total CRE loans 629 965 595 277 2,466 ($ billions) Total CRE loans as % of gross 12.7 25.1 42.1 36.0 22.4 loans and leases U.S. CRE loans 566 963 595 277 2,400 ($ billions) U.S. CRE loans as % of gross 11.4 25.0 42.0 36.0 21.8 loans and leases Construction and development loans 14.4 15.8 16.4 17.9 15.9 as % of U.S. CRE loans Multifamily loans as 24.6 21.3 17.1 10.4 19.7 % of U.S. CRE loans Nonresidential loans as % of 61.1 62.9 66.6 71.7 64.4 U.S. CRE loans
Note: Data as of June 30, 2020. CRE is commercial real estate. Total loans include loans to U.S. and foreign borrowers.
Sources: Federal Deposit Insurance Corporation, S&P Global Market Intelligence, Office of Financial Research Community banks generally according to real estate securities (MBS) and debt have large CRE exposures analytics firm Trepp LLC. during periods of financial and less diversified lending stress. portfolios (see Figure 32). Government-sponsored Community banks heavily enterprises (GSEs), Insurers, especially large exposed to CRE lending principally Fannie Mae and life insurers, are another may be at higher risk of Freddie Mac, are the second leading CRE lender, with failure when the real estate largest funders at 16.5 12.7 percent of the market cycle turns negative, percent of the market (see (see Figure 30). Insurers especially lenders exposed Figure 30). Fannie Mae and have been lending on CRE to higher-risk CRE loan Freddie Mac fund only one for decades and benefit segments such as land relatively stable CRE asset from extensive lending or development loans, or class, multifamily housing. experience. Insurers higher-risk properties such Further, the enterprises include some of the most as lodging (see Figures 33 benefit from federal conservative CRE lenders. and 34). Bank CRE loan government support, They require low LTV and defaults may not peak until allowing them to continue high debt service coverage late 2020 or early 2021, to issue mortgage-backed ratios.36 Because of their
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 49 Figure 32. Smaller Banks Figure 33. Bank Charge-off Rate by Loan Type (percent) Have More CRE Loans Relative to Total Loans and 8 Construction & development Leases (percent) Commercial real estate Multifamily 60 6
4
40 2
0 20 Jun Jun Jun Jun Jun Jun Jun Banks with $1 billion 1990 1995 2000 2005 2010 2015 2020 or less in assets Banks with $1 billion Note: Data as of June 30, 2020. The charge-off rate is realized loan losses as a or more in assets percent of total loans. The figure shows the net charge-off rate, which subtracts 0 recoveries on written-down loans from gross charge-offs. 20002005 2010 2015 2020 Sources: Moody’s Analytics REIS, Federal Deposit Insurance Corporation, Office of Financial Research Note: Data as of June 30, 2020. CRE stands for commercial real estate. CRE Figure 34. Forecasted Bank Loan Default Rates by includes nonresidential, construction and development, multifamily, and Property Type (percent) foreign real estate loans. 8 Sources: Federal Deposit Insurance Corporation, Lodging Haver Analytics, Office of Financial Research Retail Of ce conservative lending, 6 insurers have benefited Industrial from relatively favorable Multifamily credit performance on their 4 CRE lending in past stress periods.37 This will likely be the case for the current 2 credit cycle. Insurers own a wide range of debt backed 0 by CRE, with commercial mortgage-backed securities Dec Dec Dec Dec Dec Dec 2018 2019 2020 2021 2022 2023 (CMBS) being the largest portion at 31 percent, and Note: Data through March 2020 are actual; dashed are projected.
multifamily and office both Sources: Trepp LLC, Office of Financial Research around 17 percent (see
50 OFR ANNUAL REPORT TO CONGRESS 2020 Figure 35. Insurers’ CMBS Figure 36. Commercial Mortgage-backed Securities 60+ and Commercial Real Estate Day Delinquency Rate (percent) Loans by Asset Type 20 Hotel Industrial Multifamily
16 Of ce Retail
12
8 CMBS Other Multifamily Industrial Of ce Hotel Retail 4
Note: Data as of Dec. 31, 2019. CMBS stands for commercial mortgage- backed securities.
Sources: S&P Global Market Intelligence, A. M. 0 Best, Office of Financial Research Aug Aug Aug Aug Aug Aug Aug Figure 35). Insurers are 2002 2005 2008 2011 2014 2017 2020 relatively less exposed to Note: Data as of August 2020. Moody’s conduit DQT defines delinquent loans the hard-hit retail and hotel as loans that are 60 or more days in payment arrears; performing matured; properties because of the nonperforming matured; foreclosure in progress; or real estate owned. perceived higher risk in Sources: Moody’s Investors Service, Office of Financial Research those sectors even before of principal losses are those During good economic the pandemic. backed largely or exclusively times, these CMBS by higher-risk properties, forbearance complexities CMBS, with a 8.8 percent such as hotels and shopping matter little. However, in market share, are an malls (see Figure 36).38 times of market stress such important part of the CRE as now, these forbearance financing landscape (see Loans included in CMBS are complexities can result Figure 30). Banks and subject to a more complex in elevated levels of loan insurers also hold CMBS in forbearance approval defaults and credit losses by their investment portfolios in process when a loan CMBS borrowers compared addition to their ownership becomes troubled than are with loans made with more of direct loans. CMBS 39 loans held by others. flexibility. investments at highest risk
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 51 Direct lenders unaffiliated may need additional space. employment rates and with regulated financial A key unknown for office personal income. Sectors institution can lend space is how demand will most at risk are low-rent aggressively, offering fare in large, high-rise workforce housing where loans with more attractive markets dependent upon tenants are subject to borrower features such as public transit, such as layoffs and associated higher LTV ratios.40 These Manhattan, Washington, reduced income, and lenders seek higher returns Boston, San Francisco, and high-end urban housing in and assume greater credit Chicago. More automobile- the most expensive areas risk. Given the higher risk oriented cities such as such as Manhattan and profile of these loans, credit Los Angeles, Dallas, and San Francisco. Sectors losses by direct lenders are Houston may be less benefiting in the future likely to exceed those of the affected by this challenge. could include suburban more conservative lenders. apartments in large Industrial space has metropolitan areas and Asset types. Major CRE performed well in the crisis, apartments in rapidly asset types are office with an extraordinarily high growing mid-size urban buildings, multifamily July rental payment rate of areas. housing, retail, hotels, 99.4 percent.42 Industrial and industrial properties. space can be used for many The retail CRE sector The sector also includes purposes. Increasingly, has been weak for years. specialized real estate such Internet commerce The onset of COVID-19 as senior housing, student warehouses are replacing sped the deterioration. housing, medical, and retail, generating rapidly Coresight Research reports multiple-use facilities. growing demand for well- that retailers announced located warehouse space.43 more than 9,800 stores Through July, office rental Demand is strong enough closed in 2019 and that the payment collection rates that additional warehouse 2020 pace will be much were 96.4 percent.41 space is being developed higher, with numerous However, over the long run, even during the current chains filing for bankruptcy there remains uncertainty crisis, and underperforming protection (see Figure regarding the demand retail is being transitioned 37).44 The United States for office space given into warehouse space. has far more retail space conflicting space demand than its peers, and far trends. This could both Multifamily properties as more than is currently reduce rental collection a whole have performed needed.45 Shopping rates on rented space relatively well in large part malls are hard hit, as their and result in considerable due to extensive federal mainstay department stores amounts of newly vacant financial support, such as rapidly fail. Experience- space not bring in rent. The expanded unemployment oriented uses of mall space, work-from-home movement insurance. However, such as fitness facilities, may reduce office space considerable uncertainty entertainment venues, and needs, while remaining remains over the long restaurants, have been office-based employees run related to future
52 OFR ANNUAL REPORT TO CONGRESS 2020 affected by COVID-19 Figure 37. Selected 2020 Retail Bankruptcy Filings restrictions on gatherings. ($ millions) Many shopping malls may close permanently. Small local shopping areas Retailer Date Liability Range are also under pressure as consumers migrate Century 21 Dept. Stores Sep. 10 $100 to $500 to online shopping and Stein Mart Aug. 12 $500 to $1,000 venture out of their homes Lord & Taylor Aug. 2 $100 to $500 less. Credit losses in the Tailored Brands Aug. 2 $1,000 to $10,000 retail sector have been Ascena Retail Group July 23 $10,000 to $50,000 and may continue to be RTW Retailwinds July 13 $100 to $500 substantial. The CMBS Muji USA July 10 $50 to $100 retail delinquency rate was 18.1 percent for the month Sur La Table July 8 $100 to $500 ending June 2020.46 Many Brooks Brothers July 8 $500 to $1,000 of these delinquencies may Lucky Brand July 3 $100 to $500 eventually become credit GNC Holdings June 23 $500 to $1,000 losses. J. C. Penney Co. May 15 $1,000 to $10,000 Stage Stores May 10 $1,000 to $10,000 Hotels have historically been a higher-volatility Neiman Marcus May 7 $1,000 to $10,000 asset class. This downturn J. Crew May 4 $1,000 to $10,000 is no exception. Travel, Bluestem Brands March 9 $500 to $1,000 conventions, corporate Art Van Furniture March 8 $100 to $500 gatherings, and large social Pier 1 Feb. 17 $500 to $1,000 events were cancelled, bringing unprecedented Note: Liability ranges are provided in bankruptcy filings. disruption. Hotels have Sources: New Generation Research, Office of Financial Research. been operating at record properties suitable for HOUSEHOLD CREDIT low occupancy, with an longer-term residence, average September 2020 those that are lower cost, The COVID-19 pandemic occupancy rate of 48.3 and those in vacation areas introduced an extreme percent, down from 67.4 reachable by automobile.48 economic shock to percent in September households, although 47 2019. The most affected The most aggressive and household balance sheets hotels are those that CRE-exposed lenders, have not experienced as host conventions, are typically private debt much stress as some feared in major downtowns, investment funds, will likely at the onset of the crisis. or are in locations that absorb substantial credit Household debt balances can be reached only by losses in this cycle. contracted 0.5 percentage plane. Hotels performing points in April. Growth in better are extended stay debt balances has been
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 53 tepid since then due, in have provided payment Figure 38. Household part, to tighter lending deferrals on their own as Delinquency Rates by standards. Public and well, typically for three to Credit Score Category private relief measures have six months for loans without (percent) helped buttress household government backing.49 balance sheets so far, but These deferrals either 25 these relief measures will extend the maturity date eventually be phased out. of the loan or require a balloon payment of the 20 Overall delinquency rates deferred payments at the declined from 2.9 percent original maturity. Take- in January to 1.5 percent up of these programs by 15 in September. The decline borrowers rose sharply was largest for households beginning in April. For 300-619 with the weakest credit other types of household 10 620-659 profiles, that is, those with loans, auto loans (10.3 660-739 credit scores under 620 (see percent) and mortgages (8.3 740-809 Figure 38). This downward percent) have the highest 5 810-plus trend in delinquencies is forbearance rates as of July unusual for a recession. 2020. Typically, delinquencies rise 0 While these programs are sharply. Unprecedented Mar May Jul Sep policy initiatives undertaken meant to provide immediate 2020 2020 2020 2020 through the CARES Act and relief to households Note: Delinquency rate is calculated private sector relief efforts experiencing hardship due to the pandemic, there as the fraction of balances 30-plus have contributed to this days past due, by credit score reversal. Loan restructurings are potentially important category. long-term implications and forbearances on loan Sources: Equifax, Office of Financial Research for financial stability and payments have brought are higher for households relief to households the economic recovery. Negative amortization with credit scores below 620 experiencing financial (30.1 percent) compared hardship. For example, on loans in forbearance increases household with households with credit payments on federally and scores above 800 (6.7 GSE-backed mortgages leverage and may create debt overhang issues in percent). Other types of can be delayed up to 360 loans how similar patterns. days without incurring a some households. This is particularly true for While relief programs have penalty or being classified lowered delinquencies so as delinquent. Payment households with weaker credit profiles, where far, greater debt burdens deferrals have been for households that sought granted automatically on interest accruals are likely to be larger relative to relief may mean prolonged, federally held student loans elevated delinquencies over through the end of 2020. original balances. As of July, mortgage forbearance rates the long term. These risks Private credit institutions may be realized sooner
54 OFR ANNUAL REPORT TO CONGRESS 2020 Figure 39. Geography of Nonprime Household Debt (top) and COVID-19 Incidence Rates (bottom)
Nonprime household debt per capita
COVID-19 incidence rates
Note: Data for the top figure are based on the county-level per capita nonprime household debt as of February 2020. Counties with higher per capita nonprime household debt are shaded darker. Data for the bottom figure are based on county-level COVID-19 incidence rates as of Sept. 30, 2020. Counties with higher COVID-19 incidence rates are shaded darker.
Sources: Equifax, U.S. Census Bureau, Johns Hopkins University, Office of Financial Research
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 55 rather than later for many unemployment benefits. households with higher households if payment Research by the Federal credit scores. The decline grace periods or additional Reserve suggests that for households with low government stimulus are with those measures, 94 credit scores was primarily not extended. percent of households can driven by the overall cover at least six months of reduction in mortgage Household finance expenses, compared with credit supply for these vulnerabilities have about half with existing households, due in large been uneven during the savings accounts and part to tighter mortgage pandemic, with illnesses standard unemployment underwriting standards and related shutdowns benefits alone.50 mandated by post-crisis hitting households in financial reforms. some parts of the country During past recessions, harder than those in others. household leverage was a Leverage has not been Densely populated areas strong indicator of future as important a factor so with greater infection delinquencies. Coming into far during this recession, transmission correspond this recession, however, as delinquencies have to regions that had higher households had stronger remained low due to the geographical concentrations balance sheets than borrower relief measures of nonprime household before the 2007-09 crisis. described above. However, debt before the pandemic, Before this year, aggregate when these measures are or as of February 2020 (see household leverage has eventually phased out, Figure 39). The counties been steadily declining households with the highest in the top quarter of total every year since 2010. leverage are likely to be the COVID-19 incidence most vulnerable. rates as of September Household deleveraging 2020 accounted for 44.8 following the 2007-09 crisis RESIDENTIAL REAL percent of pre-pandemic was more pronounced for ESTATE total debt balances for households with credit nonprime households, and scores below 660. For Residential mortgages were 46.7 percent for prime these households, leverage a catalyst for the 2007-09 households. Unemployment remains below pre-2007- financial crisis, including claims also surged in these 09 crisis levels. There is some loans packaged into areas, raising concerns considerable diversity in nonagency residential about the household household leverage across mortgage-backed securities incomes relative to income and credit score (RMBS). Many nonagency expenses. However, various groups. Debt payment-to- RMBS were packaged policy actions through income ratios (see Figure into collateralized debt the CARES Act appear to 40) are significantly lower obligations (CDOs) that have helped subdue these for households with low were, in turn, re-securitized risks. These policy actions credit scores than they as CDOs-squared. CDOs included one-time recovery were in 2007. These ratios and CDOs-squared were payments and expanded have been similar, or have sold to a broad group of increased slightly, for
56 OFR ANNUAL REPORT TO CONGRESS 2020 Figure 40. Changes in Household Leverage by Risk and Income Groups
Income Groups 2020 2007 Change in Low Middle High All Low Middle High All DTI (‘07-’20)
300-619 18.3% 31.1% 55.1% 30.1% 19.2% 36.1% 84.8% 38.5% -8.4%
620-659 19.4% 34.5% 61.9% 35.7% 12.1% 31.2% 75.4% 38.4% -2.7%
660-739 14.6% 29.5% 52.9% 32.7% 15.8% 25.0% 57.8% 33.8% -1.1%
Risk Groups 740-799 9.9% 20.0% 38.9% 25.9% 13.7% 15.0% 39.7% 24.0% 1.9%
800+ 7.2% 9.9% 24.1% 15.5% 43.4% 8.0% 22.8% 22.8% 2.5%
All Risk 15.8% 22.1% 35.1% 17.0% 21.6% 42.6%
Note: Table entries display household leverage for each group as of January 2007 and March 2020. Leverage is measured by the debt-to-income (DTI) ratio, which is defined as total monthly payments divided by estimated monthly income. Darker colors are associated with higher DTI values. Income groups are defined as below 67 percent (low), between 67 percent and 200 percent (middle), and above 200 percent (high) of Bureau of Labor Statistics median individual income in 2007 and 2018, respectively. Risk groups are segmented using credit scores from VantageScore 3.0 scores developed by VantageScore Solutions LLC, which range from 300 (worst) to 850 (best).
Sources: Federal Deposit Insurance Corporation, S&P Global Market Intelligence, Office of Financial Research investors, thereby spreading securities made up of loans have been increasing risk beyond traditional bought and packaged by their share of mortgage buyers of RMBS. These Fannie Mae and Freddie originations (see Figure 42), securities were complex Mac; or loans backed by accounting for more than and little understood government, particularly 64 percent of originations by investors, a situation the Federal Housing as of as of June 30, 2020. that produced market Administration (FHA) and While lenders do not have and contagion risks that Department of Veterans much credit risk once loans extended well beyond the Affairs (VA), and securitized are sold to the Fannie underlying default risk of via private financial Mae or Freddie Mac or the mortgage collateral. institutions with a guarantee guaranteed by Ginnie Mae, by the Government National they may still have some Agency RMBS are now Mortgage Association put-back risk for loans that the predominant channel (Ginnie Mae). become delinquent shortly for nonbank mortgage after being originated or lenders to sell their loans Nonbank Mortgage are discovered to have to investors (see Figure Lenders. For several years, other misrepresentations or 41). Agency RMBS are nonbank mortgage lenders defects.
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 57 Figure 41. Agency and Nonagency RMBS Issuance Figure 42. Nonbank Share ($ trillions) of Mortgage Originations (percent) 3 70 Nonagency Agency 65 2 60
55 1 50
45 0 40 1996 2000 2004 2008 2012 2016 2020 Jun Jun Jun Note: Data for 2020 are for January through August. RMBS stands for residential 2016 2018 2020 mortgage-backed securities. Note: Data as of June 30, 2020. Data Sources: Securities Industry and Financial Markets Association, Office of Financial Research represent activities of the top 100 Credit Risk Transfer (CRT) transfer mortgage credit risk lenders. bonds. Fannie Mae and to private investors.52 These Sources: Inside Mortgage Finance, Office of Financial Research Freddie Mac issue CRT bonds reduce the taxpayer bonds, which are securities exposure to risk assumed in mortgage credit. These with principal repayment 2008 when the enterprises bonds are typically tied to the performance were put under government issued as mezzanine and of a reference pool of conservatorship, overseen subordinated tranches, mortgages.51 The first CRT by the Federal Housing which are subject to loss bonds were issued in 2013. Finance Agency (FHFA), before senior tranches of Since then, the structure of and invested in by Treasury. the mortgage pool. The these bonds has evolved to CRT bonds support the goal enterprises retain the include separate reference of the FHFA to reduce the senior tranche and a share pools that meet targeted enterprises’ exposure to of each of the mezzanine loan-to-value criteria. mortgage credit risk and and subordinated tranches. Higher LTV mortgage loans increase the role of private The tranches have varying are riskier, all else equal, capital in the mortgage levels of risk and investor allowing investors choices market. types depending on risk of risk-return profiles. tolerance. Asset managers Investors have been and hedge funds are CRT bonds became a receptive to CRT bonds, significant investors in CRT predominant way Fannie one of few ways to directly bonds (see Figure 43). Mae and Freddie Mac invest in residential Hedge funds are the largest
58 OFR ANNUAL REPORT TO CONGRESS 2020 Figure 43. Investors in Credit Risk Transfer Bonds at Issuance ($ billions)
16 Depository institutions Insurance companies Real estate investment trusts 12 Hedge funds & private equity Asset managers 8
4
0 2013 2014 2015 2016 2017 2018 2019 2020
Note: Issuance for 2020 is through September 30. Asset managers include sovereign funds and money managers.
Sources: Fannie Mae, Freddie Mac, Office of Financial Research holders of the riskiest bonds by the enterprises reduce their risk-based bonds. largely shut down during capital requirements the second quarter. Fannie because the bonds transfer CRT bonds have been sold Mae and Freddie Mac some of the credit risk to for less than a decade. issued no new CRT bonds investors. Regulatory capital The pandemic is the first in the quarter, although requirements are suspended time that these bonds have Freddie Mac executed two while the enterprises are faced substantial stress. new offerings in July.53 As in in conservatorship. In Prior to the pandemic, other markets, prices have May, the FHFA released a CRT bonds traded at all- rebounded since March. revised capital proposal time tight levels, meaning detailing the capital that that bid-ask spreads were Uncertainty about CRT Fannie Mae and Freddie small and large blocks of bond credit risk was high Mac would be required to bonds could trade without in the spring. Specifically, hold after they are moved significantly affecting it was difficult to assess out of conservatorship (see price. CRT bonds traded at the degree to which Financial Firm Insolvency distressed prices in March payment forbearance or Risk and Potential because of uncertainty rising delinquencies in the Contagion).54 Under this over the level and duration mortgage reference pools proposal, the risk-based of credit risk. The Federal were increasing the credit capital benefit from the use Reserve’s asset purchase risk of CRT bonds. The of CRT bonds is reduced programs to stabilize the performance of CRT bonds to $22.1 billion, about half mortgage markets provided bears continual monitoring. of the $41.3 billion under a no relief because these 2018 FHFA proposal. programs excluded CRT CRT bonds allow Fannie bonds. Issuance of new CRT Mae and Freddie Mac to
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 59 Figure 44. Percent Change in State Tax Revenue (March-August 2019 vs. March-August 2020)
WA 0.4 VT NH ME MT ND 2.6 -4.9 -2.2 -5.1 -2.4 OR MN -15.3 ID SD WI NY MA 10.2 5.6 -6.8 -5.8 WY MI IA PA CT RI NE -3.7 -6.1 -6.3 NV 2.3 IN OH UT IL -4.1 -2.7 NJ CO -3.9 WV VA -9.7 0.3 KS MO -2.0 CA -5.7 -5.7 KY -1.3 DE -8.9 -0.3 MD -2.2 NC -4.2 TN -1.1 AZ OK -3.4 -2.2 NM -6.6 AR SC -3.5 -2.0 MS AL GA -2.2 2.8 1.9 TX LA -10.6 -6.5 FL -16.5
AK -31
HI Sum of Percent Change June 2019 vs 2020 -16.47 10.16
Note: There was a 6 percent total decline for all states. States that did not have all data as of Sept. 30, 2020, include Hawaii, Michigan, New Mexico, Nevada, Oregon, Rhode Island, Utah, Wisconsin, and Wyoming.
Sources: Urban Institute, Office of Financial Research STATE AND LOCAL DEBT services provided by state in aggregate, which means and local governments have that many governments The financial effects of the risen and are predicted need to make large COVID-19 pandemic have to rise even more. For contributions to adequately been pronounced for state instance, requirements for fund their plans (see and local governments. more frequent cleaning and Pension Funds). To preserve Revenue from income taxes, for social distancing among liquidity, some sponsors sales taxes, and business students have increased the have deferred contributions. taxes has fallen (see Figure cost of running schools. For example, the state of 44). Revenue has also New Jersey announced that declined from stadiums, The additional expenses it would delay a quarterly toll roads, airports, and have come at a time when contribution of $950 million other projects built with state and local budgets to its pension fund by municipal bond debt (see are already under pressure. one month. New Jersey’s Figure 45). At the same Pension plans for state pension fund is only 38 time, expenses for health and local governments are percent funded.55 care, education, and other substantially underfunded
60 OFR ANNUAL REPORT TO CONGRESS 2020 State and local New York’s Metropolitan $3.9 billion in municipal governments have already Transportation Authority are bonds outstanding in May tried to cut budgets through the only current borrowers 2020, 26 percent were various means, including by from that facility. general obligation bonds, laying off workers. Finding 64 percent were revenue new sources of revenue States and localities rely bonds, and 10 percent were to replace those that were heavily on debt to build classified as other.56 lost has been challenging infrastructure and run since raising taxes can be essential services (see Defaults at the state level politically difficult or, in Figure 46). The two main are unlikely, according to 57 some jurisdictions, legally types of municipal debt credit rating agencies. impossible. The Federal are general obligation General obligation bond Reserve’s Municipal bonds — backed by a defaults have been low Liquidity Facility is available government’s overall tax for the last decade, and to buy short-term debt from revenue — and revenue are expected to stay that states and certain counties, bonds — backed by specific way. There has been one cities, or other entities to revenue streams. Of the municipal default since the help them bridge cash flow problems. Illinois and Figure 46. Proceeds of Municipal Bond Issuance (percent of par value) Figure 45. Estimated Revenue Losses ($ billions) State Hospitals Estimated Water and sewer Loss for Issuer FY 2021 School district Toll roads, bridges, and tunnels States 290 Higher education Cities 117 Appropriation Counties 114 Airports Transit systems 24 Income tax nancing Water systems 14 City Sewer systems 12 Electricity and public power Toll Roads 9 Sales tax Total 580 Government lease County Note: Fiscal year (FY) 2021 began July 1, 2020. $580 billion in total Tax-backed district losses equals 38 percent of FY 2019 tax revenues. 0 5 10 15
Sources: Census Bureau, Center on Budget and Policy Priorities, EBP US, Inc., Note: Breakdown uses Bloomberg/Barclays’ bond classification. Those International Bridge, Tunnel, and Turnpike categories below 2 percent of relative par value are not shown; they total 18 Association, National Association of Counties, percent in 27 categories. National League of Cities, Raftelis, Office of Financial Research Sources: Barclay’s Municipal Bond Total Return Index, Bloomberg Finance L.P., Office of Financial Research
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 61 pandemic started, Fairfield, Figure 47. Municipal Bond Issuance ($ billions, percent) Alabama in May, but that city’s financial problems Total ($ billions, left axis) 58 100 30 predate the pandemic. High yield (percent, right axis) A few other especially stressed localities might 80 default. Credit rating 20 agencies expect most 60 municipal bond defaults to come from bonds backed 40 10 by dedicated revenue streams. 20
High-yield municipal market 0 0 issuance has grown in 2000 2004 2008 2012 2016 2020 market size to $85 billion in 2019 from $5 billion Note: 2020 issuance includes debt issued through Sept. 30, 2020. High-yield sectors are not based on ratings but defined as nursing homes, hospitals, in 2000. However, the casinos, prisons, industrial improvements, charter schools, student housing, percentage of municipal retirement homes, parking, parks, recreational facilities, stadiums, and bond issuance that can be university improvements. classified as high yield has Sources: Bloomberg Finance L.P., Office of Financial Research varied from year to year their risk profiles. Bonds PENSION FUNDS between the mid-teens and supported by communal high twenties for the past living facilities, such as Many pension funds across 20 years (see Figure 47). senior and student housing, the United States are In total, high-yield bonds could be at substantial risk significantly underfunded account for 20 percent of as a result of the social as the present value of all municipal bond issued distancing required by the benefit liabilities exceeds between 2000 and 2020. pandemic. Other sectors their assets. The size of the funding gap reflects, among The high-yield municipal such as charter schools other factors, the discount market is not characterized and private colleges could rate used to calculate as such by the bonds’ credit be at risk due to changes future liabilities and on ratings, but by the relatively in educational delivery the assumed investment higher risk of the type of methods, the requirements returns used to project issuers. Sectors perceived of social distancing, and asset growth. Pension as high risk include, increased cleaning costs. plans are designed with for example, schools, Convention centers, the expectation of earning hospitals, and toll roads, stadiums, and other large adequate returns over a and are not necessarily indoor meeting areas long-term horizon. If these traditional municipal could be affected if large returns are not realized, issuers. The revenue gatherings take place less plan sponsors have to streams backing these frequently. increase plan contributions, bonds vary, along with
62 OFR ANNUAL REPORT TO CONGRESS 2020 pressuring the overall Figure 48. Pension Underfunding ($ trillions) finances of the sponsor. 8 Data from the Federal State/local government Reserve allow comparison Private plans of funding levels for private 6 Public & private plans and public pension funds.59 Private pension funds were underfunded at 4.8 4 percent, while state and local government plans in aggregate are deeply underfunded at 48.3 2 percent as of June 30, 2020 (see Figures 48 and 49).
0 In the United States, Jun Jun Jun Jun Jun Jun there are about 6,000 2005 2008 2011 2014 2017 2020 public pension plans
Note: Data as of June 30, 2020. Public and private category includes federal with a combined $4.4 pension plans. trillion in assets and more
Sources: Board of Governors of the Federal Reserve System, Office of Financial Research than 25 million retired and active workers as 60 Figure 49. Pension Underfunding (percent) plan participants. The COVID-19 pandemic 60 worsened an already difficult situation for many 50 U.S. public pension funds. Increased expenditures 40 by state and local State/local government governments, along with 30 Private plans falling tax revenue due Public & private plans to the pandemic, have 20 increased the pressures faced by state and local governments. This 10 incentivizes them to skip their regular pension plan 0 contribution (to the extent Jun Jun Jun Jun Jun Jun they can) and also makes 2005 2008 2011 2014 2017 2020 it unlikely that they will Note: Data as of June 30, 2020. Public and private category includes federal have the ability to top up pension plans. the underfunded pension Sources: Board of Governors of the Federal Reserve System, Office of Financial Research amounts anytime soon.
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 63 If sponsors are unable to investment income. sponsors increase their increase their contributions, Alternatively, they can shift leverage through Pension then pension funds may their asset allocation to Obligation Bonds (POBs). instead try to close the gap higher-risk and higher-return POBs are taxable municipal by relying on increasingly or alternative investments. securities issued by state aggressive investment Pension plans for state and or local governments to strategies. local governments have meet pension obligations. increased their allocations Investors in POBs look to Pension plan liabilities are in hedge fund and private the state or municipality sensitive to interest rate equity investments as well for interest and principal changes, with declining as real estate (see Figure payments. The pension fund interest rates raising the 50). would have more assets to cost of future benefits. invest as well as lower its As most pension funds California Public unfunded liabilities. It can have sizable fixed-income Employees’ Retirement leverage the low borrowing allocations, achieving System, the largest public costs and invest in higher- targeted investment returns pension plan in the United yielding assets to increase becomes more difficult as States, recently announced its investment income. interest rates decline. With that it would increase its interest rates remaining low, investments in private Many pension benefits plan sponsors may have to equity and use leverage are enshrined in state law substantially increase their to boost its expected and practices, making it future plan contributions investment returns.61 difficult for plan sponsors to to make up for lower Some public pension fund reduce future benefits and thereby reduce liabilities. Figure 50. Public Pension Fund Investments (percent) Chapter 9 of the U.S. Bankruptcy Code allows 100 Other municipalities to reorganize Cash and renegotiate terms with 80 Real Estate creditors.62 Bondholders Hedge fund/ and pension plans would private equity 60 have conflicting interests Fixed income in renegotiating terms with Equities the municipality. States (and 40 by default state-sponsored pension plans) are not able 20 to file for bankruptcy. They usually are required by state 0 law to balance their budget Dec Dec Dec Dec Dec Dec Dec annually. If a state is unable 2001 2004 2007 2010 2013 2016 2019 to meet its obligations, it would likely default. Note: Annual data as of Dec. 31, 2019.
Sources: Public Plans Database, Office of Financial Research
64 OFR ANNUAL REPORT TO CONGRESS 2020 The federal Pension Benefit debt of 28 countries, and are not heavily exposed Guaranty Corporation put 54 others on negative to emerging market operates two separate watch for possible future sovereign debt, many Asian programs, the Single- downgrades.64 These ratings and European banks are. Employer for standard plans actions suggest that several Connections between U.S. and the Multiemployer countries, including some and foreign banks exposed Insurance Programs for large ones, have rising to risky sovereign debt joint plans sponsored by default risk. So does the could transmit losses to U.S. multiple employers and an persistent increase in credit banks. affiliated union. Each of default swap spreads (see those programs allows for Figure 51). Without support Sovereign debt risk can payment of benefits, up to through organizations be characterized in four a legal maximum limit, to such as the European categories: retirees in private defined Central Bank (ECB) and • benefit pension plans the International Monetary Large economies, such where sponsors cannot pay Fund, some sovereign as India, Italy, the United promised benefits. The debt will remain tenuous Kingdom, and Japan, Multiemployer Insurance at best. While U.S. banks had fiscal constraints Program is financially challenged and is expected Figure 51. Selected Five-year Credit Default Swap to run out of money to pay Spreads for Six Countries (basis points) benefits by the end of FY 63 700 2026 or 2027. Turkey Italy 600 FOREIGN GOVERNMENT Mexico DEBT Russia 500 India The COVID-19 pandemic is Japan not expected to constrain 400 foreign government debt issuance over the 300 near term. Credit market conditions remain favorable 200 for rolling over this type of debt, and there has 100 been support to the most vulnerable countries 0 through mechanisms such Sep Nov Jan Mar May Jul Sep as World Bank Group 2019 2019 2020 2020 2020 2020 2020 debt service suspension. However, in the first half Note: Shows five-year contracts of the same maturity. The spread is the price of the credit default swap. A spread of 100 basis points means that it costs of 2020, credit rating $1 to insure $100 of debt. agencies downgraded the Sources: Bloomberg Finance L.P., Office of Financial Research
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 65 going into this crisis. other single sources of was in 1940, when the For example, Japan and income, such as Egypt, country defaulted on its Italy have high debt- Turkey, and Costa Rica, obligations in the same year to-GDP ratios. Italy is experienced sharp it entered World War II. at increasing risk of income declines with the default, as discussed reduction in travel. As As the pandemic unfolded, in more detail in this long as the COVID-19 Italy was particularly section. Japan suffers pandemic continues, hard hit, with more than from persistently low these countries face a 35,000 deaths. The economic growth. The dire financial outlook. country’s economic hub, United Kingdom faces Without international the Lombardy region, was economic headwinds and support, their finances locked down for months. costs associated with its could become The Italian government separation from the EU. unsustainable. rolled out a series of Financing costs for these economic packages to stem countries will increase • Stronger economies the economic decline, at over time, possibly with diversified income a cost of €70 billion-€100 making fiscal austerity sources, such as the billion.65 Coupled with a measures necessary over United States, China, drop in GDP, Italy’s debt- the long run. and Germany, are taking to-GDP ratio rose to 155 on debt equal to more percent by May.66 Italy is • Nations dependent on than 10 percent of gross forecast to reach a debt-to- oil and other commodity domestic product. That GDP ratio of 180 percent by revenues may not be much debt can threaten year-end if fiscal conditions able to provide fiscal long-term growth and remain in the present state, stimulus to counteract risks inflation. bringing it closer to that of the effects of the Greece.67 COVID-19 pandemic on Italy’s debt could become their economies. Mexico, problematic down the road. What is keeping the Italian Oman, and Iraq, for Coming into the COVID-19 sovereign bond market example, were already crisis, Italy already displayed afloat and at depressed facing fiscal pressures characteristics associated yields is the ECB’s Public coupled with weak with a sovereign debt Sector Purchase Program economic growth. These crisis. The Italian economy (PSPP). Italian bonds make nations face a difficult was experiencing high up more than 22 percent of choice between fiscal unemployment and sluggish the PSPP’s purchases. The austerity and increasing growth. More important, the ECB could end up owning their debt and risk of country had a debt-to-GDP more than 40 percent of default. Ecuador has ratio close to 135 percent. Italian government bonds already restructured its That amount of debt is by the end of 2020. debt. common for countries on the verge of default. In For now, Italy’s interest • Nations largely fact, the last time Italy had payments total a dependent on tourism or amassed that much debt manageable 5 percent of
66 OFR ANNUAL REPORT TO CONGRESS 2020 GDP, with yields averaging 1.2 percent. Moreover, ARGENTINA’S HISTORY OF DEFAULTS a recently negotiated European Union €750 billion economic stimulus package On May 24, Argentina failed to make good on a will boost Italy’s GDP.68 coupon payment of $500 million due to its creditors, However, there is a risk marking the ninth default in its history. The first that at some point, without was in 1827, 11 years after independence. In concerted intervention from 1913, Argentina’s GDP was larger than that of the the ECB and fiscal support United States. Since then, however, the country from the EU, investors may has experienced a vicious cycle of recessions, become more reluctant hyperinflation, and serial defaults. This year, the to buy Italian bonds as country’s GDP is expected to contract as much as 12 the debt service coverage percent. ratio becomes increasingly Argentina knows from experience how to deal with unsustainable. the demands of creditors and the International Problems are already Monetary Fund while retaining its domestic priorities. apparent in Argentina. The IMF supports a debt restructuring offer made by On May 24, Argentina Argentina’s government on May 26, citing the need defaulted on its debt for for a sustainable debt-to-GDP ratio through 2030. The the ninth time in its history proposal suggests a two-year moratorium on payments (see Argentina’s History instead of the initial three years, along with principal of Defaults). Argentina’s reductions of 7 percent for debt due in 2030 and 5 financial and economic percent for debt due in 2035 and 2046. Striking a deal position is not unusual in could avoid years of legal battles and prevent the emerging markets. Like country being locked out of global capital markets, other emerging market which happened in the 2001 default. The offer was countries encountering a agreed to by the largest creditor group on August 69 deteriorating fiscal situation, 4. Argentina conceded on the payment dates on Argentina does not have the new bonds, keeping the value of the bonds the well-diversified sources of same despite the reduction in principal. Following revenue. Argentina’s debt- the agreement, Argentina’s bonds maturing in 2028 to-GDP ratio is 89 percent, were trading at 46 cents on the dollar. The IMF is also based on year-end 2019 taking a softer stance with respect to Argentina’s plan debt of $325 billion, and its to repay a $56 billion standby agreement received in inflation rate is 45 percent. 2018. Argentina can potentially delay four payments Several smaller and even due during 2021 to 2023, as well as austerity measures medium-size economies set to take effect around the same time. are experiencing similar tumult, adding pressure to multilateral institutions and wealthier countries to
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 67 continue their support. Of The quick and aggressive Markets and Credit note is the instability of the policy response to stabilize Availability). The Federal Turkish lira, which lost 40 the economy and markets Reserve’s actions and the percent of its value over six subsequently drove a CARES Act coincided months. Turkish consumer recovery in valuations with investors resuming prices rose 11.8 percent and ensured that markets purchases of risky assets. year-over-year in August, continued to function News regarding antiviral the 10th straight month of amid the sell-offs and treatments and vaccine double-digit price increases. volatility spikes. Given the development efforts also financial market recoveries, contributed to higher MARKET RISK vulnerabilities remain from investor confidence. The elevated equity valuations S&P 500 gained 60 percent Market volatility can pose and high bond duration. from the March low through a risk to financial stability early September, reaching through widespread STOCK MARKETS a new record high. The simultaneous investment recovery was driven by the Stock markets declined losses, margin calls, and technology sector, which on deteriorating investor the disorderly unwinding of was perceived as less sentiment, increasing trading positions. Liquidity vulnerable to the negative uncertainty, and falling effects can be transmitted effects of the pandemic. expectations for earnings to other markets and Other sectors have not fully with the arrival of the market participants. For recovered, as reflected COVID-19 pandemic in the years prior to the pandemic, in the Russell 2000 Index United States. The S&P market risk was elevated by of small-capitalization 500 index fell 34 percent high equity valuations and stocks, which as of the end between its February 19 considerable duration risk in of September remained then-record peak and its fixed-income markets. With down 11.6 percent from March 23 bottom. In late the COVID-19 pandemic its January peak. With the March, consensus earnings and resulting lockdowns, partial rebound in equity estimates for 2020 were investors fled risky assets prices, there is a risk that down 7.2 percent from for the security of cash. The unexpected increases the start of the year, and severity of market reactions in COVID-19 infections continued to fall as the year may have reflected both and the reinstatement of progressed. the economic effects of the lockdowns could adversely pandemic and government affect consumer and Beginning on March efforts to contain the health business confidence and 16, the Federal Reserve threat.70 Containment thus once again curtail announced lending facilities efforts have harmed economic activity and cause to assist U.S. businesses in service-oriented and global investors to reduce their weathering an economic businesses the most. These exposure to risky assets. downturn expected to types of businesses have be unprecedented in Implied stock market grown as a share of the U.S. its severity (see Federal volatility as measured by economy over time. Reserve Actions to Support
68 OFR ANNUAL REPORT TO CONGRESS 2020 the Chicago Board Option have profits and losses buyer of credit protection Exchange Volatility Index, that are greater than the might be a lender that wants often called the VIX, was volatility of underlying to hedge against a borrower the highest since the fall of asset prices. To take on a default. The seller insures 2008, averaging 58 during derivatives position, the the underlying debt and March, up from the mid- parties to the contract(s) will pay in case of a default. teens in January and the first must post initial margin The CDS spread measures half of February. Realized in the form of cash or the cost of that credit volatility, as measured by Treasuries. This initial protection. For example, a absolute monthly return margin protects each party spread of 100 basis points for the S&P 500 index, was in the event of default by means that it costs $1 to the second highest ever the counterparty. Also, for insure $100 of debt. in March. Average daily each day the contract is trading volume in March set active, one party must post The volatility of the CDS a record at almost 16 billion variation margin to the other market produced a surge of shares. Additionally, single- in an amount equal to the calls to post higher margins. day price declines in March change in the trade’s market The CDX North America were some of the largest in value. investment-grade and high- history. The S&P 500 index yield CDS indexes rose fell 12 percent on March 16 Market volatility in March to peaks of 151 and 834 and 9.5 percent on March led to unusually large basis points, respectively, 12. These large one-day variation margin payments. compared with 45 and 294 declines triggered market- The parties that had to post basis points just one month wide circuit breakers four variation margin sometimes prior (see Figure 52). Bid- times (see How Well Did raised the cash via sales ask spreads hit peaks of the Circuit Breakers Work?). of assets referenced by 7.6 and 25.5 basis points, Despite high volatility and derivatives contracts, respectively. As in the trading volume, there were creating a feedback loop. 2007-09 crisis, a number of no major issues with market Initial margins also increased institutions with significant infrastructure. as liquidity and counterparty derivatives exposures credit declined along with experienced large losses. DERIVATIVES MARKETS market volatility. However, fewer failed this time, due in part to stronger Derivatives contracts such As an example of the capital positions to weather as futures, listed options, volatility experienced by losses and liquidity positions and swaps have values derivatives markets, credit to meet margin calls. derived from the underlying default swap (CDS) spreads instruments, products, and transaction costs spiked Margin calls were or indicators, such as during late March to levels significant for sellers of interest rates, currencies, rarely seen since 2008. A credit default protection. equities, commodities, CDS allows an investor to A large proportion of or precipitation levels. “swap” or offset its credit calls for existing positions Derivatives positions can risk with that of another were for variation margin investor. For example, a payments, though initial
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 69 margin increased globally protection sales (largely to increased from the prior by 31 percent. Between hedge funds) from February year-end and remains just late February and mid- to March by $55 billion. below its 2018 peak. The March, cumulative net This amount equaled one- duration of the Bloomberg variation margin payments third of their protection Barclays U.S. Aggregate totaled around $32 billion purchases earlier in the Bond Index is 6.1 years as for net sellers protection, year. While derivatives of September 2020, above based on data from markets in general, and its long-term average the Depository Trust & CDS markets specifically, of 4.85 years. Given Clearing Corporation. Asset remain vulnerable to future the current duration, a managers were collectively stress, during the spring’s percentage point increase the largest net protection instability they displayed in interest rates would lead sellers, while broker- resilience, albeit with help to a decline of 6.1 percent dealers — trading in their from the Federal Reserve’s or $1.5 trillion in the market own accounts and for their facilities. value of the Barclays clients — were the largest Index. More specifically, net buyers. As CDS spreads BOND MARKETS an increase in rates of only rose, margin payments 0.19 percentage points (19 flowed from asset managers Bond prices decrease basis points) would cause to broker-dealers. Payments with increases in interest a market price decline that were concentrated in a few rates, all else equal. Bond would entirely offset the institutions. As conditions duration — a measure of income of the Barclays improved in subsequent bonds’ price sensitivity to Index. weeks, protection sellers interest rate changes — experienced reduced mark-to-market losses and Figure 52. Credit Default Swap Indexes (basis points) requirements for margin. 1,000 High-yield index The timely flows matter Investment-grade index because during market 800 stress periods, dealers act as intermediaries in the CDS market. In this role, 600 dealers may satisfy demand for protection purchases 400 from other institutions. Their capacity to bear related risks 200 owes, in part, to the profit they make on hedges and 0 offsetting positions. Because asset managers were able to Jan Mar May Jul Sep 2020 2020 2020 2020 2020 make their margin payments to dealers, dealers were Note: Series are the Markit North American 5-year index composites.
able to increase their Sources: Markit, Office of Financial Research
70 OFR ANNUAL REPORT TO CONGRESS 2020 HOW WELL DID THE CIRCUIT BREAKERS WORK?
Today’s market-wide circuit breakers were created in response to the October 1987 market crash. They are a failsafe measure that forces a pause in equity trading, and equity-related options and futures trading, in the event of severe declines in the S&P 500 index. Trading pauses allow traders and investors time to reassess asset valuations, and allow central counterparties and brokerages to make margin calls if necessary. There are three levels of market-wide circuit breakers, and they go into effect automatically under the following conditions:
A Level 1 circuit breaker is triggered if the S&P 500 index LEVEL 1 declines 7 percent from its level at the close of the previous 7% trading day. The trading day runs from 9:30 a.m. to 4:00 p.m. Eastern Time. A Level 1 circuit breaker halts trading for 15 minutes if the drop occurs before 3:25 p.m. LEVEL 2 A Level 2 circuit breaker, which halts trading for another 15 13% minutes, is triggered if the index declines 13 percent from its previous close before 3:25 p.m.
LEVEL 3 20% A Level 3 circuit breaker, which halts trading for the rest of the day, is triggered if the index declines 20 percent.
The Level 1 circuit breaker was triggered on March 9, 12, 16, and 18. For the first three days, the breakers were triggered within 15 minutes of the start of the trading day (see Figure 53). On March 9 and 12, the triggers did not occur immediately with the price decline. This was because the calculation to trigger the circuit breaker requires that a stock in the S&P 500 index trade at least once before its value within the index is updated. Several stocks included in the index did not trade until several minutes after the market opened. This delay allowed for several S&P 500-linked derivatives products to trade at prices below the trigger threshold.
The system for implementing the breakers functioned well, and trading venues and traders were well-prepared for this rare event and the level of coordination
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 71 Figure 53. Four Days Market-wide Circuit Breaker Halted Trade
March 9
282 Price (left, dollars) 1,000 279 Volume (right, thousands of shares) 100 276 10 273 Circuit breaker 270 1 9:30 AM 9:35 AM 9:40 AM 9:45 AM 9:50 AM 9:55 AM 10:00 AM
March 12 282 Price (left, dollars) 1,000 279 Volume (right, thousands of shares) 100 276 10 273 Circuit breaker 270 1 9:30 AM 9:35 AM 9:40 AM 9:45 AM 9:50 AM 9:55 AM 10:00 AM
March 16 282 Price (left, dollars) 10,000 279 Volume (right, thousands of shares) 1,000 276 100
273 Circuit breaker 10 270 1 9:30 AM 9:35 AM 9:40 AM 9:45 AM 9:50 AM 9:55 AM 10:00 AM
March 18 242 Price (left, dollars) 10,000 239 Volume (right, thousands of shares) 1,000 236 100
233 Circuit breaker 10 230 1 9:30 AM 9:35 AM 9:40 AM 9:45 AM 9:50 AM 9:55 AM 10:00 AM
Note: The plot presents the SPDR S&P 500 Trust ETF’s price (dark blue) and logarithmic volume (light blue), and highlights the four market-wide circuit breaker periods in March 2020.
Sources: May Street, NYSE, NASDAQ, Office of Financial Research
72 OFR ANNUAL REPORT TO CONGRESS 2020 required. The only other time the Level 1 circuit breaker was triggered was in 1997.71 For these four events in March, the halting and resuming of trade was orderly. There were only a few minor changes made to implementation by the primary exchanges and Securities Information Processors — which link quoted prices and trades for various markets into consolidated data feeds — over the two-week period.
The circuit breakers appear to have been successful in helping to stem the market decline. Although stock prices continued to trend down at the end of the trigger periods for at least a few minutes, they then returned to more typical patterns for short-term price changes.
Investors accept this and funding squeezes and up to 30 days of financial duration risk in an effort produce spillovers among stress. Deposits, which are to seek higher investment the affected markets. relatively more stable than yields in what is a very wholesale funding, also low risk-free interest rate FINANCIAL flowed into banks. environment. Market INSTITUTIONS participants see the risk of In contrast, some an unexpected sharp rise in When lenders lose nonbank financial entities interest rates as low. confidence in borrowers, experienced temporary they can curb funding. challenges managing 72 LIQUIDITY AND Banks and other types of liquidity. For example, FUNDING RISK financial firms are vulnerable some prime money to funding risk given their market funds experienced unusually high customer When the COVID-19 role as short-term borrowers redemptions. Under pandemic hit the United and long-term lenders. In ordinary circumstances, States in earnest, it 2020, however, it wasn’t just money market funds sparked a liquidity and confidence in borrowers experiencing significant funding panic for financial that was an issue. It was liquidity demands would institutions and markets. also that investors held onto have met those demands Normal market functioning their cash rather than buy by drawing on cash and has largely returned, more debt instruments. cash equivalents, income but only with continuing Banks mostly avoided earned on investments, and monetary and fiscal support. funding and liquidity temporary lines of credit, The primary vulnerability problems this year. One or by selling securities was, and still is, co- reason is that large banks with embedded gains or dependencies among some maintain liquidity buffers that are trading close to debt issuers and investors that generally exceed their par value. However, whose actions during crises regulatory requirements before the Federal Reserve’s tend to amplify liquidity calibrated to withstand Money Market Mutual
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 73 Fund Liquidity Facility Bond mutual funds and 3.5 percent outflow over (MMLF) was initiated, some exchange-traded funds 16 weeks. The Federal prime institutional money also experienced liquidity Reserve’s Secondary Market market funds turned to challenges in March, in Corporate Credit Facility their sponsors for liquidity part driven by concerns addressed the illiquidity of support.73 The MMLF about the credit quality and this market. provided loans to banks liquidity of fund holdings. The Federal Reserve’s to finance purchases of These funds were invested actions restored liquidity in eligible assets from prime in high-yield assets, the financial system. Fund and municipal funds. Once investment-grade corporate outflows soon shifted to the MMLF was established, debt, and sovereign debt. inflows. However, given the several money market funds Bond funds recorded the uncertainty still surrounding sold securities to affiliated sharpest outflows since the the course of the pandemic, and unaffiliated financial 2007-09 financial crisis, liquidity risk remains institutions via the facility with nearly a 3 percent elevated for funds providing to raise liquidity to meet outflow rate across bond investors with ready access redemptions while also open-ended mutual funds to their money. maintaining weekly liquidity and exchange-traded funds ratios above the regulatory over just a few weeks (see Real estate lenders, 74 minimum of 30 percent. Figure 54). This outflow investors, and mortgage occurred much more quickly servicers have faced a Liquidity crises tend to than during the 2007-09 different set of funding get worse when investors crisis, when there was a anticipate potential net asset value declines or Figure 54. Bond and Exchange-traded Funds redemption gates, and Experienced Sharp Outflows, Then Stabilized (percent) increase their redemptions accordingly. As a result, the 3 MMLF played an important 2 role in helping money 1 market funds maintain high asset liquidity essential 0 for meeting redemption -1 demands. But, as discussed -2 later in this section, the -3 liquidity problem for money market funds spilled over -4 into funding problems for -5 commercial paper issuers Jun Sep Dec Mar Jun because money market 2007 2010 2013 2017 2020 funds are one of the largest Note: Trailing four-week net flow rates for U.S. bond mutual funds and classes of investors in these exchange-traded funds. assets. Sources: EPFR Global, Haver Analytics, Office of Financial Research
74 OFR ANNUAL REPORT TO CONGRESS 2020 and liquidity challenges. risk that they are stuck Nonbank financial firms Some of the problems were holding and funding loans now service more than brought on by mortgage- on their balance sheet half of agency residential backed securities market longer than planned. mortgages, collecting disruption. Other problems Their reliance on rapid payments on behalf of were brought on by securitization compounds investors (see Figure 55). forbearance policies that this risk. These firms face liquidity allowed borrowers to delay risk from a mismatch payments. Liquidity and Many mortgage lenders between the timing of funding problems were hedge their new-loan their cash inflows and most acute for nonbank pipelines with short outflows made worse by mortgage lenders and positions in the MBS the pandemic and the servicers, which unlike market. The Federal policy response to assist banks do not have access Reserve’s purchases of MBS borrowers. to loans via the Federal restored the market, but The CARES Act requires Reserve discount window. also contributed to MBS price gains that led to large mortgage servicers to Nonbank mortgage lenders margin calls to mortgage grant payment forbearance get most of their funding for lenders on their short to borrowers who are mortgages from warehouse positions. experiencing financial loans. A warehouse loan is a line of credit, usually with Figure 55. Nonbank Share of Agency Mortgage-backed a bank. Warehouse lending Security Servicing (percent) involves two stages. In the first stage, the nonbank 70 lender uses the mortgage as collateral to draw on 60 the warehouse line. In the second stage, the nonbank 50 is responsible for finding a buyer for the mortgage 40 it used as collateral. Once the mortgage is sold, the 30 proceeds are paid to the Total warehouse lender, which 20 Fannie Mae then releases the mortgage Freddie Mac collateral. 10 Ginnie Mae
Disruptions in the MBS 0 market that dry up investor Jun Jun Jun Jun Jun Jun demand and thus hinder 2015 2016 2017 2018 2019 2020 new MBS issuance quickly expose these lenders to Note: Data as of June 30, 2020. “pipeline risk.” This is the Sources: Inside Mortgage Finance, Office of Financial Research
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 75 hardship and who have servicers are generally up to four months of mortgages backed by the required to advance advances, capping the risk. government or by Fannie principal and interest Real estate investment Mae and Freddie Mac. payments to investors trusts that invest in Forbearance can be granted even if servicers receive no residential and commercial for 180 days and extended payments from borrowers MBS also experienced for an additional 180 days. for loans in forbearance. liquidity problems brought These advances strain on by the MBS market The share of residential the liquidity of nonbank turmoil. Some REITs had mortgage loans in servicers without other difficulty selling MBS in forbearance has been sources of revenue. The the secondary market declining from peak levels agencies adopted special or meeting margin calls. reached in May. Mortgages pandemic-related provisions Generally, highly leveraged in Ginnie Mae-guaranteed to ease those strains. Ginnie REITs finance their MBS securities, which include Mae established backstop assets with repurchase FHA and VA loans, have financing for its servicers agreements (repos). Federal the highest percentage of to mitigate this risk. Fannie Reserve MBS purchases loans in forbearance at 9 Mae and Freddie Mac offered only partial relief percent as of September require servicers to provide (see Figure 56). Mortgage to this market because the purchase program does not apply to most Figure 56. Residential Mortgage Servicers Saw mortgage REIT holdings. Improving Shares of Loans in Forbearance (percent) Some mortgage REITs 14 experienced substantial market value declines in 12 March, with some of the largest REITs losing between 10 12 percent and 69 percent of their market capitalization 8 from January to mid-March. In many cases, values 6 Ginnie Mae mortgages recovered only partially by summer. 4 Depository institutions Total mortgages Liquidity tightened in the 2 Independent mortgage bankers MBS market, in part, due to Fannie Mae/Freddie Mac mortgages 0 selling pressure from REITs experiencing funding stress. Mar Apr May Jun Jul Aug Sep 2020 2020 2020 2020 2020 2020 2020 The Federal Reserve’s announcements during the Note: Data as of Sept. 27, 2020. Share of residential mortgage loans in week of March 16 resolved forbearance, by percent of servicers’ portfolio. the liquidity squeeze Sources: Mortgage Bankers Association Forbearance and Call Volume Survey, Office of Financial affecting the MBS market. Research
76 OFR ANNUAL REPORT TO CONGRESS 2020 Figure 57. Mortgage Rates Decline After Federal Figure 58. FHLBs’ Reserve Intervention (percent) Estimated Funding Gap Widened Further in 2020 30-year xed rate 4 (percent) Rate spread 0 3
2 Start of -10 1 intervention
0 -20 Jan Mar May Jul Sep 2020 2020 2020 2020 2020 -30 Note: The ICE BaML Bond index is the Corporate Master Total Return Bond Index.
Sources: Intercontinental Exchange, Standard & Poor’s, Haver Analytics, Office of Financial Research -40 By summer, mortgage rates during the second quarter 2010 2015 2020 were at historic lows (see — the largest percentage Note: Data as of June 30, 2020. FHLB Figure 57). decline in any quarter in at stands for Federal Home Loan Bank. least 13 years. However, The funding gap equals liabilities due The Federal Home Loan this decline followed a first- in one year less liquid assets, with Banks (FHLBs) increased the result divided by total assets. A quarter increase of 25.8 their exposure to funding 2 percent discount was applied to percent as members sought securities inventory and a 100 percent risk in 2020. Specifically, the liquidity. The second- haircut was applied to fixed assets, gap between the maturity held-to-maturity securities, and held- quarter decline was, in of FHLB borrowing and to-maturity mortgages with legal part, the result of maturing maturities greater than one year. lending widened further in or prepaid short-term Sources: FHLB 10-K and 10-Q filings, Haver 2020 (see Figure 58). advances amid improved Analytics, Office of Financial Research The combined assets of the financial market conditions. distortionary downward FHLBs fell by 9.7 percent price pressures — and from year-end 2019 to the FINANCIAL MARKETS also can lead to funding end of June, driven by a problems, when lenders decline in advances.75 The A market is said to be liquid won’t advance money. A FHLBs provide advances when buyers and sellers key characteristic of a liquid — loans secured by can easily trade significant market is when the price the eligible collateral, such as volumes of financial buyer wants to pay (the bid) residential mortgages — to instruments without much and the price at which the their bank and nonbank price impact. An illiquid seller is willing to sell (the members. FHLB advances market risks fire sales — ask) are not far apart. This is declined by 30.9 percent when participants can’t sell called a narrow spread and securities without adding it is a characteristic of the
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 77 ineligible securities reflects Figure 59. Bid-ask Spreads for Off-the-run Treasuries an increasing difference Spiked in March ($) in liquidity for these two 3.0 otherwise similar securities.
2-Year The immediate cause 2.5 5-Year of illiquidity was large Treasury sales to dealers, 10-Year whose balance sheets were 30-Year 2.0 already stretched leading into March. Between January 2018 and January 1.5 2019, primary dealer net coupon Treasury exposure 1.0 more than tripled, from $66 billion to $199 billion. Throughout 2019, that 0.5 primary dealer exposure remained high and as of January 2020 was $162 0.0 billion. By March 18, this Dec Jan Feb Apr May Jun Jul Aug Sep number had risen to $222 22 24 27 1 6 9 13 17 21 billion. This high Treasury exposure makes it difficult Note: Spreads are the difference between bid and ask prices for $100 notional in the fourth-from-most-recent Treasury issuance as of January 2020. for dealers to make markets,
Sources: Bloomberg Finance L.P., Office of Financial Research because the intraday trading activity requires U.S. Treasury market, the securities. The price of taking on additional most liquid market in the on-the-run Treasuries rose Treasury exposure, which world. However, in March, relative to comparable when exposures are already liquidity in the Treasury maturity off-the-run high may pose challenges market deteriorated on Treasuries, reflecting an to the dealer’s risk. Sales sustained selling pressure. increasing difference in by other Treasury investors Around March 3, spreads liquidity. Similarly, the to dealers were behind rapidly widened, especially price of Treasury securities this increase in exposure. bid-ask spreads for longer- eligible for delivery to These sales generally maturity off-the-run Treasury satisfy the obligations of appear to have been securities (see Figure 59). a futures contract rose concentrated in off-the- relative to comparable Off-the-run Treasury run securities, as investors maturity Treasuries not securities are outstanding sought the liquidity of cash eligible. As with on- and notes issued before the and Treasuries that could off-the-run securities, this most recent, and most more easily be sold for increasing price difference traded, on-the-run Treasury cash. Although a variety of between eligible and
78 OFR ANNUAL REPORT TO CONGRESS 2020 Treasury investors sought Treasuries decreased by Pool, which effectively to sell their holdings, two $85 billion, with a further removes reserves from the sources of sales illustrate decrease of $51 billion domestic financial sector; if important vulnerabilities in between March 18 and all else is equal, this makes the Treasury market. March 25. Sales by foreign funding Treasury holdings official accounts may have through repurchase First, sales by domestic been particularly deleterious agreements more expensive and foreign “real money” for dealers because primary for dealers. The general investors, which consist dealers are required to increase in reserves over of nonbanks and foreign make reasonable markets this period may have eased central banks, played a for sales by official these effects on repo rates. key role. Federal Reserve accounts. The effect of Sales by foreign official data show that mutual these foreign official sales accounts slowed after the fund Treasury positions was compounded by the Federal Reserve introduced decreased by $196.8 investment of much of the its FIMA Repo Facility and billion between the fourth proceeds in the Federal expanded availability of quarter of 2019 and the Reserve’s Foreign Repo swap lines, moves that let first quarter of 2020. This decrease may have been Figure 60. Foreign Official Treasury Holdings in Custody the result of redemptions with the Federal Reserve and the Foreign Repo Pool by mutual fund investors, ($ billions change from 2018) and little was picked up by other domestic nonbank 150 actors such as pension or insurance funds. Sales by 100 foreign official accounts appear to have been 50 particularly large. Treasury International Capital data 0 show a total decrease in foreign Treasury holdings -50 of $257 billion, with $147 billion in sales from official -100 Foreign of cial custody accounts. Examining the holdings of Treasuries Federal Reserve’s releases Foreign repo pool -150 on these foreign official accounts’ custody holdings of Treasuries provides a -200 higher-frequency view Dec Sep Jun Mar 2017 2018 2019 2020 (see Figure 60). Between February 26 and March 18 Note: Data are from Federal Reserve Release H.4.1 and are changes from level of 2020, these accounts’ at the beginning of January 2018. Repo stands for repurchase aggreements. custody holdings of Sources: Board of Governors of the Federal Reserve System, Office of Financial Research
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 79 foreign official accounts Figure 61. Hedge Fund Treasury Exposure and Futures get cash without selling Positions ($ billions) Treasuries. 1,500 A second factor that may Treasury long exposure have contributed to the Treasury short exposure Short Treasury futures position Treasury market’s reduced 1,000 liquidity was securities Long Treasury futures position selling among hedge funds to meet margin calls (see 500 Market Risk). Long Treasury exposure for hedge funds, which is profitable 0 when prices rise, fell by Jan Jan Jan Jan Jan Jan Jan Jan $242 billion (17 percent) 2013 2014 2015 2016 2017 2018 2019 2020 during March, while short Treasury exposure, which Note: Data as of June 30, 2020. Long and short Treasury exposures are from SEC Form PF, aggregated over all reporting hedge funds. Futures positions are from is profitable when prices Commodity Futures and Trading Commission (CFTC) Commitment of Traders fall and largely represents data, and are leveraged fund long and short positions measured as dollars of short exposure to Treasury notional value. futures, fell by $170 billion Sources: CFTC Commitment of Traders, Securities and Exchange Commission Form PF, Office of Financial Research (19 percent) (see Figure 61). The decline in long Figure 62. Change in Long Treasury Position During exposure was concentrated March 2020 by Leverage Deciles ($ billions, ratio) among more levered funds (see Figure 62). The $203 40 9 billion (19 percent) decline 8 in gross long exposures in 0 7 the highest leverage group -40 (those in the top 10 percent Change in Treasury long 6 -80 position (left axis, $ billions) by leverage) is likely, in 5 Weighted average leverage part, declines in positions -120 (right axis, ratio) 4 due to sales by hedge funds 3 involved in cash-futures -160 2 Treasury basis trades. This -200 type of trade seeks to 1 exploit the price difference -240 0 between cash Treasury 1st 2nd 3rd 4th 5th 6th 7th 10th9th8th securities and Treasury Note: Deciles of leverage are determined as of December 2019. Leverage is futures, and much of gross asset value over net asset value. Averages are weighted by net asset hedge fund short Treasury value within deciles. Change in Treasury position uses gross long Treasury exposure is associated with positions as of the end of March less gross long Treasury positions as of the end short futures positions. If of February. Sources: Securities and Exchange Commission Form PF, Office of Financial Research
80 OFR ANNUAL REPORT TO CONGRESS 2020 this difference is bigger Reserve also temporarily reverse repos attractive. than the cost of buying lowered regulatory capital These transactions are risky the Treasury security and requirements that reduced for dealers. To short an on- financing that purchase the capacity of dealers to the-run Treasury, a dealer in the repo market, then purchase the unusually engages in a reverse repo, the trade is profitable. large volume of Treasury bringing in the on-the-run These trades achieve high securities being sold.77 Treasury by lending cash leverage through repo at a low — often negative borrowing. OFR research Sustained illiquidity in — special collateral casts some doubt on the Treasury market also rate. The dealer rolls the how central hedge fund distorted repo rates, transaction over until the sales of the cash-futures especially in markets on-the-run Treasury can basis specifically were to where lenders can specify be secured. If the dealer amplifying Treasury market the exact collateral they fails to secure the Treasury, illiquidity.76 However, receive, such as the or if borrowers with that selling was high across DVP Service run by the security are unavailable, many other hedge fund Fixed Income Clearing the dealer is subject to strategies. Corporation. The relatively both a charge for failing to high prices of on-the-run deliver the Treasury security Treasury market liquidity Treasuries made shorting and the loss of the money normalized after the Federal Treasury securities through the dealer lent against Reserve addressed supply- demand imbalances, first Figure 63. Average DVP Repo Rate by Collateral by expanding its repo Runness (percent) facility to reduce dealers’ carrying costs. Reducing 2.0 these costs made it more feasible for dealers to 1.5 On-the-run buy and hold additional 1.0 Off-the-run Treasuries on their balance sheets, expanding these 0.5 balance sheets in the process. Through its 0.0 normal repo operations, the Federal Reserve -0.5 makes loans to primary -1.0 dealers collateralized by eligible securities such Jan Feb Mar Apr May Jun Jul 2020 2020 2020 2020 2020 2020 2020 as Treasuries. Second, the Federal Reserve Note: Data as of July 28, 2020. Average rates for overnight repurchase began directly buying agreement (repo) transactions via the Fixed Income Clearing Corporation’s DVP Service using on-the-run or off-the-run Treasuries as collateral. Dashed lines Treasuries to offset selling denote reopenings of the 10-year note and 30-year bond. pressure. The Federal Sources: OFR Cleared Repo Collection, Office of Financial Research
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 81 the security. The volume These special collateral cleared markets increased of these special collateral transactions took place dramatically, especially in transactions, known as amid broader stress in the DVP Service’s sponsored specials, led to negative cleared repo markets, which borrowing market and the average rates in some in the United States include GCF Repo Service. The sections of the repo market the Fixed Income Clearing effective federal funds (see Figure 63). Specials Corporation’s DVP Service, rate followed the increase activity has been especially a bilateral market, and GCF in repo rates, rising to high directly preceding Repo Service, a tri-party meet the upper bound reopening of the 10-year market with only general on the target range. With and 30-year Treasury collateral trades. Repo rates the March 17 expansion securities, when dealers can in March experienced high of the Federal Reserve’s rely on the supply of the on- levels of volatility during the repo facility, which lends to the-run Treasury increasing general flight to liquidity dealers, these rates broadly in the near future. (see Figure 64). Leading fell, eventually meeting into March 17, repo rates in the lower bound set by
Figure 64. Overnight Spreads Over Federal Funds Target and Volume in Federal Reserve Facilities (percent, $ billions)
300 GCF rate (left axis) DVP intermember rate 250 0.8 (left axis) DVP sponsored lender RP Facility Volume (right axis) rate (left axis) ON-RRP Facility Volume (right axis) 200 DVP sponsored borrower rate (left axis) 150 Effective federal funds rate (left axis) 0.3 100
50
-0.3 0 Jan Feb Mar Apr May Jun 2020 2020 2020 2020 2020 2020
Note: Data as of July 28, 2020. Rates for the Fixed Income Clearing Corporation’s DVP Service and GCF Repo Service, two venues for repurchase agreement (repo) transactions, are weighted average overnight rates for Treasury collateral. The two black lines show the average rate offered by the Federal Reserve’s Repo Facility (RP, upper line) and Overnight Reverse-Repurchase Facility (ON-RRP, lower line). The shaded areas are daily transaction volumes in these facilities.
Sources: Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, OFR Cleared Repo Collection, Office of Financial Research
82 OFR ANNUAL REPORT TO CONGRESS 2020 the reverse-repo facility. commercial paper holdings Conditions in short-term While the movements in by nearly 30 percent in funding markets gradually facility volumes were large first quarter 2020. At the improved, with three-month throughout late March and same time, commercial commercial paper rates early April, the Federal paper issuers, particularly returning to typical spreads Reserve appears to have nonfinancial companies above overnight indexed been broadly successful in with few alternative sources rate swaps (see Figure 65). its control of rates. Since of short-term funding, This spread is a proxy for May, rates have begun experienced greater short- stress induced by firms’ to slowly increase, and term funding needs under collective need to draw on participation in these the stress of the pandemic. their bank lines of credit in facilities has broadly fallen. The Federal Reserve’s place of issuing commercial Commercial Paper Funding paper. The A2/P2 rate Liquidity fell and rates Facility allowed issuers to applicable to lower credit- spiked in other short- buy back their outstanding quality issuers was the last term funding markets, commercial paper and commercial paper rate to too. Prime money market reissue it. This facility normalize. funds sought to reduce reduced funding stress for their commercial paper most issuers. However, the The market’s problems in holdings and raise cash to facility does not address March were very different meet investor redemptions. funding pressures of lower- from those experienced Also, securities lending credit-quality commercial during the 2007-09 cash collateral reinvestment paper issuers or support crisis, when asset-backed accounts reduced secondary market liquidity. commercial paper was
Figure 65. Three-month Commercial Paper (CP) Interest Rate Spread over the Overnight Indexed Swap (OIS) Rate (percent)
4.0 90-day AA-rated Federal Reserve 3.5 nancial paper spread over 3-month OIS 3.0 90-day AA-rated non nancial CP spread 2.5 over 3-month OIS 90-day AA-rated asset-backed CP 2.0 spread over 3-month OIS 1.5 90-day A2/P2-rated non nancial CP 1.0 spread over 3-month OIS 0.5 0.0 -0.5 Sep Dec Mar Jun Sep 2019 2019 2020 2020 2020
Sources: Federal Reserve Bank of New York, Bloomberg Finance L.P., Office of Financial Research
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 83 issued to fund risky LEVERAGE IN THE leverage in the first residential mortgage- FINANCIAL SYSTEM quarter while hedge funds backed securities. deleveraged. Disruptions experienced Use of debt has the in 2020 affect all types of BANKS potential to increase investment-grade firms returns, yet it can also dependent on commercial Bank leverage increased compound losses from risks paper for their short- moderately in the spring, already discussed. Higher term funding needs, both along with increases in leverage is associated with financial and nonfinancial. loans and deposits, but a higher risk of insolvency. remains lower than the Financial sector leverage Figure 66. Financial Sector average since 1973 (see ticked up in the first quarter Figure 67 Leverage Is Low (percent) ). As of June of 2020, but remains 30, 2020, bank holding 100 relatively low for the post- companies maintained World War II period (see regulatory capital ratios Figure 66). The change 98 about 1.5 times to 2.2 times in 2020 reflects a reversal above what is considered of trends since the 2007- by regulators to be well- 96 09 crisis. Banks increased capitalized (see Figure 68). Larger banks, particularly 94 Figure 67. Bank Leverage the global systemically Rises (percent) important banks (G-SIBs), 92 hold additional capital, 92 some of which is specified 90 by regulation. High Average since 1973 1960 1980 2000 2020 capital buffers going into this crisis help to ensure 90 Note: Data as of June 30, 2020 and that banks can continue are from Federal Reserve Release Z.1. Leverage measured as total liabilities supporting the economy over total financial assets of the through lending without financial sector. 88 materially increasing risk Sources: Board of Governors of the Federal to stability of the banking Reserve System, Haver Analytics, Office of Financial Research system (see Financial Firm Insolvency Risk and 86 Potential Contagion). Even Jan Mar May Jul Sep so, the Federal Reserve 2020 2020 2020 2020 2020 has effectively temporarily Note: Data are from Federal Reserve lowered the amount of release H.8. Shows commercial bank required capital as an liabilities as a percentage of total additional way of ensuring assets. that banks can increase Sources: Board of Governors of the Federal 78 Reserve System, Haver Analytics, Office of their lending. Specifically, Financial Research
84 OFR ANNUAL REPORT TO CONGRESS 2020 Figure 68. Average Bank Holding Company Capital Figure 69. Insurer Risk- Ratios Are Much Above Well-capitalized (percent) Based Capital (percent)
16 Above well-capitalized Threshold for well-capitalized 2017 2018 2019
12 Life 465 420 430 Property 312 308 312 & casualty 8 Health 304 310 312
4 Note: Values reflect average actual amounts of adjusted capital as a percent of risk-based capital required for each category. 0 Sources: Insurer statutory filings, S&P Global Total Tier 1 Common Tier 1 Market Intelligence, Office of Financial risk-based risk-based equity Tier 1 leverage Research risk-based fairly consistent over time. Note: Data as of June 30, 2020, and are from Federal Reserve Forms Y-9C. Risk- The current leverage based ratios are based on regulatory definitions of common equity Tier 1, Tier is lower than the levels 1, and total capital divided by risk-weighted assets. The leverage ratio is Tier 1 capital divided by adjusted total assets. The definition of “well capitalized” leading up to the 2007-09 is based on the FDIC’s Prompt Corrective Action (PCA) guidelines. While this financial crisis. Leverage standard applies to insured depositories, it is used as a proxy for bank holding at life insurers remains companies. consistently higher than that Sources: Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve System, Office of Financial Research of property and casualty or health insurers (see Figure the Federal Reserve allows against unexpected 70). banks to which its rule is insurance underwriting applicable to temporarily losses, investment HEDGE FUNDS exclude reserves and impairments, or other Treasury securities adverse developments. Hedge funds can affect the from the denominator Bond rating downgrades stability of financial markets when calculating their and defaults would strain when they make drastic supplementary leverage insurers’ investment changes to their investment ratio requirement. portfolios and lead to higher positions. Hedge funds required capital charges. invest heavily in risky asset INSURANCE COMPANIES Life insurers’ investment classes such as equities, and credit risk account for corporate credit, and Insurers began 2020 with more than half of their total commodity futures. Market healthy levels of risk-based required capital. effects can be particularly Figure 69 capital (see ). pronounced for large funds Generally, these capital Leverage for each of the that are more leveraged. As cushions serve as buffers insurance sectors remains a result, changes in hedge
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 85 Figure 70. U.S. Life Figure 71. Hedge Fund Leverage by Size (ratio) Insurers Have Higher Leverage Than Other 25 Top 10 funds by GAV Insurers (ratio) Next 40 funds 20 Remaining funds 25 15 20 10 15 Life 5 10 Property & casualty Health 5 0 Jun Jun Jun 0 2016 2018 2020 Jun Jun Jun Jun Jun Note: Data as of June 30, 2020. GAV stands for gross asset value. Leverage ratio 2004 2008 2012 2016 2020 is defined as GAV divided by net asset value as reported on Form PF Questions 8 and 9. Size cohorts are based on rankings by GAV Note: Data as of June 30, 2020. Leverage is the ratio of assets to Sources: Securities and Exchange Commission Form PF, Office of Financial Research policyholder surplus, which is the difference between an insurer’s assets coinciding with the negative Hedge fund leverage and its liabilities. hedge fund performance also provides information Sources: Insurer statutory filings, S&P Global early in the COVID-19 about investor flows and Market Intelligence, Office of Financial Research pandemic, can be partly risk appetite. Reductions fund leverage serve as an attributed to the decision in leverage, for example, indicator of changes in the making of hedge funds can signal current and risk hedge funds can pose engaging in relative value future flows out of funds. to financial stability. and macro strategies (see Such outflows can be Figure 72).79 For example, destabilizing if investment Average leverage for the in 2020 alone, relative value advisors are forced to 10 largest hedge funds, and macro funds reduced sell large positions. To measured as the average their leverage from 22.0 that end, some recent ratio of gross assets (the to 18.2 and 12.9 to 8.7, data on investor flows market value of assets on respectively. To assess these suggest that COVID-19- a fund’s balance sheet) to trends while simultaneously related withdrawals were net assets (the value of placing more emphasis on significant early in the year. investors’ equity), peaked larger size, funds’ leverage Based on survey data from at 24.6 in June 2019 and within a strategy group analytics firm eVestment, fell to 15.9 as of June 2020 are weighted by their roughly $37.6 billion or (see Figure 71). Leverage gross asset size, with the 1.2 percent of total assets also fell significantly for the underlying assumption that under management left next 40 largest funds. For larger funds pose greater the industry from January the remaining funds, there financial stability risks. through August 2020. has been little change. The Outflows were concentrated overall decline in leverage,
86 OFR ANNUAL REPORT TO CONGRESS 2020 volatility is balanced. Figure 72. Hedge Fund Leverage by Strategy (ratio) Achieving this risk balance 30 requires, for example, levering up and purchasing additional assets with lower 20 volatility. Conversely, with higher volatility assets, less leverage is used. Although 10 risk parity strategies are designed to exhibit more consistent performance 0 across market environments, Jun Jun Jun 2016 2018 2020 the market turbulence in March led to an unusual, Relative value Macro Multistrategy Credit simultaneous decline in Equity Event-driven Managed futures both equity and bond prices, which caused large Note: Data as of June 30, 2020. Within a strategy, leverage is weighted by gross losses. For example, the asset value. The leverage ratio is defined as gross asset value divided by net asset value as reported on Form PF Questions 8 and 9. A fund is assigned to S&P risk parity index lost a given strategy if 75 percent or more of its gross value reported on Form PF 11.1 percent during March. Question 20 is dedicated to that strategy. A fund is considered multistrategy if no strategy satisfies the 75 percent threshold. For both of these types
Sources: Securities and Exchange Commission Form PF, Office of Financial Research of strategies, policy actions taken by the in funds that specialized in strategies were the basis Federal Reserve and macro, long-short equity, trade (discussed above in U.S. government helped Liquidity and Funding Risk and directional credit ) alleviate stress. With 80 strategies. While the and risk parity strategies. respect to the basis trade, percentage figure seems Evidence suggests that spreads narrowed and the large, it is important to note Treasury market illiquidity pressure on relative value that outflows were relatively led to significant losses at funds eased on March 16- low compared with the highly leveraged relative 17 as the Federal Reserve 2007-09 financial crisis, value hedge funds using the provided an additional 82 when some hedge fund basis trade strategy. The source of demand for monitors reported that more losses might have forced Treasury securities. Other than 5 percent of assets some funds to unwind their policy actions, including under management left the trading positions. Funds the fiscal stimulus package 81 industry. with risk parity strategies in late March, contributed also experienced large Several hedge fund to easing market volatility, losses in March. These which alleviated sell-offs strategies experienced strategies are constructed significant losses in the across asset classes due to so that the contribution the risk parity strategy. first quarter, particularly of each asset’s volatility in March. Two such to aggregate portfolio
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 87 CURRENT EXPECTED CREDIT LOSS ACCOUNTING FRAMEWORK
The Incurred Loss Model (ILM) and the Current Expected Credit Loss Model (CECL) are accounting frameworks for creating provisions for credit losses. The frameworks apply to firms that prepare financial statements in conformity with U.S. Generally Accepted Accounting Principles and have certain financial assets exposed to credit risk on their balance sheets. The 2007-09 financial crisis raised concerns about the timing of loss recognition with ILM. Specifically, under the ILM, a firm provides for credit losses only when the asset is impaired as of the date of the financial statements and the firm can reasonably estimate the size of the loss. While this was in accordance with accounting guidance under the ILM, the increased provision expense reduced income available to increase capital, which threatened the financial system by stressing bank capital at the worst possible time. In response, the Financial Accounting Standards Board developed CECL. In January 2020, 243 larger banks replaced ILM with CECL as planned.88 Ten more banks adopted CECL during the second quarter.89 For other firms, the framework takes effect for fiscal years beginning after Dec. 15, 2022, with early adoption permitted.
The ILM can limit the buildup of loss allowances early in a recession, when the economy is slowing but defaults have not risen much. The accounting standards board developed CECL in an attempt to make firms’ financial reports more forward looking and better aligned with report users’ needs. Under CECL, losses must be forecast over the life of any financial assets within the scope of the CECL framework, not just loans and leases. Provisions are made when credit is extended and revised on an ongoing basis. Firms estimate their credit losses based on historical experience, current conditions, and “reasonable and supportable” forecasts.90 Firms have considerable leeway in how they develop their estimates.
Potential concerns about a reduction in lending due to adoption of CECL and the way it affects reserves have been affected by the timing of its adoption during the same quarter the COVID-19 pandemic hit. The relative effects of the pandemic and CECL adoption on reserves vary by bank. An analysis of 23 banks with more than $50 billion in assets found that these banks’ adoption of CECL at the beginning of the calendar year increased their total reserves by $18.8 billion.91 However, that total was much smaller than the $31.3 billion these banks set aside during the first quarter to cover expected losses associated with the recession. For other banks with more than $10 billion in assets, reserve increases for pandemic-related losses and CECL adoption have been similar. For consumer banks (for example, credit card issuers), the impact of CECL adoption on reserves was larger than for the pandemic.
88 OFR ANNUAL REPORT TO CONGRESS 2020 FINANCIAL FIRM cited a decline in economic • Greater use of INSOLVENCY RISK activity and an increase in teleworking and virtual loss provisioning as drivers services, which can AND POTENTIAL of this earnings decline. increase cyber risk CONTAGION Over the longer term, all vulnerabilities; financial firms with business • More sensitive processes models based on borrowing Credit, market, liquidity, performed outside short term to lend long term and funding risks can all of bank-owned or face challenges to their threaten the solvency authorized properties solvency from low interest of financial firms. When and devices, which rate margins (see Declining these risks are realized as can increase the risk of Net Interest Margins Are losses, those losses can be fraud and potential for a Long-term Threat to magnified by the use of exposure of customer Financial Institutions). leverage. Highly leveraged sensitive information; Earnings replenish capital, financial firms are at greater and risk of insolvency, and can which mitigates the risk of threaten the solvency of insolvency. • Increased use of online other financial firms via their and mobile systems, interconnections. Contagion Banks. For U.S. G-SIBs, which may stress or risk, in turn, can expand aggregate net income adversely affect banks’ with the number and declined by 59 percent telecommunications complexity of financial firms’ from the first half of 2019 capacity. interconnections with each through the first half of 84 other. 2020. An aggregate These additional operational 408 percent increase in risks required increases FINANCIAL FIRM provisions for credit losses in bank monitoring, was an important driver oversight, and mitigation INSOLVENCY RISK of this decline. Provisions, procedures. Moreover, in turn, rose with banks’ Macroeconomic and credit these bank operations expectations for pandemic- risks are particularly high, must keep pace with the related losses and the given the uncertainty rapid implementation of concurrent adoption of the about the pandemic’s pandemic-related business new current expected credit course and how continuity plans and loss accounting standard households, businesses, transitioning from traditional (see Current Expected and policymakers will operations to a heightened Credit Loss Accounting react. Lenders are already operational level. While Framework). feeling the effects. The not a likely threat to FDIC reported 70 percent bank solvency in and of As a result of steps taken declines in net income for themselves, these additional during the pandemic, the banking industry in the costs and risks have hit banks also have higher first and second quarters banks at the same time that operating costs and risks.85 of 2020 compared with a macroeconomic and credit Heightened costs and risks year earlier.83 The agency risks are elevated. are associated with:
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 89 The Federal Reserve’s to between 9.5 percent and at greater risk of insolvency annual large bank holding 7.7 percent. Under the U- than larger banks due to company stress tests — the and W-shaped scenarios, concentrations in exposures Comprehensive Capital most banks would remain to particular risky sectors Analysis and Review (CCAR) well capitalized, but such as commercial real — provide an important several would approach estate or risky industries gauge of solvency risk minimum capital levels. The such as oil and agriculture. within the banking system sensitivity analysis did not When smaller banks face and financial stability more incorporate potential effects insolvency, local economies generally. CCAR tests the of government stimulus can suffer without posing a robustness of banks’ capital payments and expanded risk to overall U.S. financial to losses that can occur unemployment insurance. stability. during periods of financial stress. This year, in addition In light of these results, As discussed above, an to its normal stress test, the the Federal Reserve took area of particular concern Federal Reserve conducted several actions to bolster is banks’ exposures to a sensitivity analysis to bank resilience should commercial real estate. A assess the resilience of macroeconomic and bank’s risk of insolvency large banks under three credit risks be worse than from CRE and CMBS hypothetical economic expected. In the second exposures can be assessed scenarios that could half of 2020, large banks by looking at the size of result from the COVID-19 must not repurchase their these exposures relative pandemic.86 The scenarios shares. In recent years, to the bank’s capital. included a V-shaped share repurchases have Large exposures — those recession and recovery; a accounted for about 70 exceeding three times slower, U-shaped recession percent of shareholder tangible common equity — and recovery; and a payouts from large banks. are concentrated among W-shaped, double-dip Large banks also must limit hundreds of smaller banks recession. their dividend payouts to that hold a small, but not 100 percent of the trailing insignificant, portion of In those three scenarios, the four quarters of earnings. industry assets (see Figure unemployment rate peaked In recent years, some of the 73). Of the 5,114 banks at between 15.6 percent largest banks have paid out analyzed, 1,431 banks and 19.5 percent, which is dividends exceeding their totaling 15.3 percent of significantly worse than any earnings. The results of industry assets had large of the Board’s pre-pandemic this year’s stress test were CRE exposures at the end stress test scenarios. In also used to set new capital of June. When combined aggregate, loan losses for requirements for 34 banks with their CMBS securities the 34 banks tested ranged with assets of more than held in portfolio, 1,528 from $560 billion to $700 $100 billion. banks totaling 19 percent billion and capital ratios of industry assets had large declined from 12 percent in These new requirements exposures. That is, when the fourth quarter of 2019 took effect on October 1. CMBS are also considered, Many smaller banks can be
90 OFR ANNUAL REPORT TO CONGRESS 2020 some time (see Figure 74). Figure 73. Many, but Not Most, Banks Have High CRE A sustained period of lower Exposures as a Multiple of Tangible Common Equity interest rates exacerbates (top) (number of banks) and Banks with High CRE the narrowing of this spread Exposures as a Multiple of Tangible Common Equity Are between the amount of Mostly Small (bottom) (percent of industry assets) money the company can 1,600 earn on investments and the CRE crediting rate on insurance policies. 1,200 CRE and CMBS Insurers have tried several 800 ways to enhance investment yields. These include 400 extending the maturities of their investments and 0 taking on more credit < 1 1-2 2-3 3-4 >4 risk. They have also increased investments in less liquid and sometimes 60 CRE more complex securities. CRE and CMBS These include private 40 placements, mortgage loans, and alternative investments (see Figure 20 75). Insurers, particularly life insurers, have also used securities lending and 0 repurchase agreements, < 1 1-2 2-3 3-4 >4 funding agreement-backed securities, and Federal Note: Data as of June 30, 2020. Commercial real estate (CRE) loans and Home Loan Bank borrowing commercial mortgage-backed securities (CMBS) held in portfolio. Multiples of tangible common equity of three or more are high. to earn spread income that enhances their portfolio Sources: Federal Deposit Insurance Corporation, Office of Financial Research yields. a relatively small number Insurers. Ten-year U.S. of additional banks have Treasury yields have Government-sponsored large exposures relative to fallen below 1 percent, enterprises (GSEs) Fannie their capital. This change is and a prolonged low-rate Mae and Freddie Mac. reflected in the modest shift environment could be likely. Fannie Mae and Freddie in the distribution of bank Insurers, particularly U.S. Mac have been under exposures from the left to life insurance companies, conservatorship since the right along each figure’s have been facing a decline 2008. One requirement to horizontal axis. in their spread income for exit conservatorship is to maintain capital that meets
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 91 requirements that boost Under a proposal the FHFA be required to hold a their resilience to future issued in May, Fannie Mae combined $243 billion stress. and Freddie Mac would of capital. This amount is based on the enterprises’ Figure 74. Life Insurance Industry Yields (percent) financial statements dated Sept. 30, 2019, and is much 2.0 Net spread (left axis) 7 larger than the $137 billion Guaranteed interest rate (right axis) that would have been 6 1.6 Net portfolio yield (right axis) required under a previous 5 proposal in 2018. Fannie 1.2 Mae and Freddie Mac held 4 a combined $27.9 billion in capital on June 30, 2020.87 0.8 3 2 The 2020 proposal for 0.4 risk-based capital uses a 1 framework similar to that of the international Basel 0.0 0 capital framework for 2006 2008 2010 2012 2014 2016 2018 banks. The 2020 proposal Note: Net spread is the difference between the net portfolio yield and the also includes a leverage guaranteed interest rate. capital requirement for the
Sources: National Association of Insurance Commissioners, Office of Financial Research two housing GSEs. Each enterprise would have to Figure 75. Life Insurers Have Increased Their Less-liquid hold the higher of the risk- Investments (percent) based capital requirement or leverage requirement. 60 Alternative investments Mortgage loans Under the proposed rule, Fannie Mae and Freddie Private placements 40 Mac must hold capital that exceeds the requirements in order to avoid limits 20 on capital distributions and discretionary bonus payments. The amount of capital the two housing 0 GSEs would need to Dec Dec Dec Dec Dec Dec 2009 2011 2013 2015 2017 2019 raise, about $215 billion, remains an obvious issue Note: Investments as a percentage of invested assets. Alternative investments to their potential exit from include, for example, hedge funds and private equity, or specialty investments conservatorship. such as mineral rights and aircraft leases.
Sources: Insurer statutory filings, S&P Global Market Intelligence, Office of Financial Research
92 OFR ANNUAL REPORT TO CONGRESS 2020 DECLINING NET INTEREST MARGINS ARE A LONG-TERM THREAT TO FINANCIAL INSTITUTIONS
A combination of low expected productivity growth, low inflation risk, and increasing demand for safe assets has pushed down Treasury rates across the yield curve. Lower rates, and especially lower term premiums, could have consequences for the profitability of financial institutions. The yield curve influences the return on maturity transformation, which the term premium approximates. With short-term rates pinned by the zero lower bound and long- term rates declining, the profitability of maturity transformation has generally been declining (see Figure 76). At the same time, borrowing long term becomes more attractive and lending long term becomes less attractive, placing more pressure on financial intermediaries as entities such as nonfinancial firms increase the duration of their liabilities.
Figure 76. Recent Declines in Term Premiums Have Not Been Associated with Declining Bank Interest Margins (percent)
6 Bank net interest 5 10-year term premium 5-year term premium 4
3
2
1
0
-1
-2 1992 1996 2000 2004 2008 2012 2016 2020
Note: Data as of Aug. 14, 2020. Term premiums are from the ACM term structure model. Net interest margin is an aggregate for all U.S. banks.
Sources: Adrian, Crump, and Moench (2013), Federal Financial Institutions Examination Council, Federal Reserve Bank of New York, Federal Reserve Bank of St. Louis, Office of Financial Research
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 93 The exposure of financial institutions to declining yield curve spreads likely depends on their source of funding. Commercial banks may be less exposed as they exercise some market power on their consumer deposits, meaning that increases in short-term rates are not fully passed through. In fact, when short-term interest rates were rising beginning in 2016, consumer deposit rates barely rose, and the aggregate net interest margin for banks increased. On the other hand, for institutions relying on wholesale funding, the effects of changes in the yield curve are much more direct. Repo rates are closely tied to short- term returns such as those on Treasury bills, and the extent to which market power can be exercised in these markets is likely limited. With the more recent increase in slopes of the yield curve, the position is reversed: for retail banks, the deposit rate paid has little room to decrease, while long-term rates continue to decline. For nonbank financial firms, the decrease in the short-term rate more directly increases the margins they can expect to earn.
CONTAGION RISK The system remained to default.92 The index WITHIN THE FINANCIAL functional, albeit with depends on the size of the SYSTEM unprecedented government bank, its leverage, and how support as the Federal connected it is to other Contagion risk is the risk Reserve backstopped entire financial institutions. that stress at one financial markets. Contagion index values institution or part of the Global Systemically for the U.S. G-SIBs were financial system spills over Important Banks. Eight U.S. generally unchanged from to others. It can arise from bank holding companies are 2016 through the end of asset and liability exposures identified by the Financial 2019. In early 2020, as net to other parties, or from Stability Board as G-SIBs worth and leverage rose, disruptions to financial whose failure could pose a index values also rose. The market infrastructure. threat to the international index values rose at least 30 Exposures among financial system. The OFR’s percent in the first quarter counterparties in derivatives Bank Systemic Risk Monitor for 10 of the 36 banks for markets and other sources presents a collection of which the OFR calculates of interconnection among key public measures for its index. The increases large financial firms can be monitoring systemic risks were due mainly to growth a major vulnerability. These posed by these banks in securities lending and networks of contractual and their global peers. over-the-counter (OTC) relationships can spread Among those measures is derivatives liabilities. Some stress and losses when the OFR Contagion Index, large banks continue to shocked. The shock from which computes the loss have index values that the COVID-19 pandemic that could spill over to are more than twice the tested the resilience of the rest of the financial average of the others due the U.S. financial system. system if a given bank were to their size and degree of
94 OFR ANNUAL REPORT TO CONGRESS 2020 connectivity with the rest of Figure 77. U.S. Banks’ Financial Claims on G-10 the financial system. Countries (percent of total for group) Foreign G-SIBs are a potential source of United Kingdom contagion for U.S. banks Japan with cross-border claims Germany on these institutions. As Q2 2020 France shown in the OFR’s Bank Q2 2019 Systemic Risk Monitor, Canada Q2 2018 some European G-SIBs are Switzerland large relative to most other G-SIBs. Some of these Luxembourg banks have performed Netherlands poorly since the 2007-09 crisis. Others have been hit Italy hard by the pandemic. Four Belgium of the five largest European Sweden G-SIBs reported second quarter 2020 earnings 0 5 10 15 20 25 30 declines ranging between 7 percent and 96 percent. The Note: Claims on Luxembourg (not a G-10 country) also shown. Total exposures pandemic raises the risk of a equal 12-13 percent of total U.S. commercial banking assets in each quarter. Sources: Federal Deposit Insurance Corporation, Federal Financial Institutions Examination Council, European bank default with Haver Analytics, Office of Financial Research potential spillovers to the U.S. banking system. U.S. which help to prevent cross- little capital and too much banks’ risk of loss through border contagion risk.93 reliance on short-term financial claims on residents funding. Derivatives of G-10 countries and Counterparties. Luxembourg were steady The credit default swap at 12 to 13 percent of total Derivatives trades, market, especially CDS on U.S. commercial banking whether to hedge risk mortgage-backed securities assets from first quarter or to speculate, create and other asset-backed 2018 through first quarter interconnections among securities, was a key source 94 2020 (see Figure 77). While banks and nonbanks. of systemic risk then. This the potential for U.S. bank While hedging can reduce market channeled housing losses is a concern, it is not risk to portfolios, the market risk through the likely to pose a risk to the interconnections can financial system. At the stability of the U.S. financial increase contagion risk. time, most swaps were system given regulatory Leading up to 2008, the traded bilaterally, or OTC, measures and cooperative lack of funding, capital, rather than through an agreements put in place and collateral requirements exchange or clearinghouse. after the 2007-09 crisis, allowed too much risk to The network and its web be taken by firms with too of risks were unregulated
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 95 and opaque. In that crisis, manage counterparty loss if a clearing member, defaults accumulated and risk. Although increased or its client, defaults. CCPs dealers failed to maintain clearing through CCPs manage the risk of default market liquidity. has mitigated bilateral primarily by requiring counterparty risk, CCPs members to post initial The 2010 Dodd-Frank Act have become potential margin payments, plus aimed to close regulatory sources of systemic risk. In variation margin payments gaps in derivatives markets, particular they are potential assessed as market values of including by requiring sources of contagion positions change. Under the that certain derivatives be due to overlapping pandemic-induced stress of cleared. The Commodity memberships (see Mapping early 2020, CCPs generally Futures Trading Commission Interconnections Among performed well. There were now requires that certain Central Counterparties). To only a few defaults during OTC interest rate swaps prevent them from acting the extremely volatile and index CDS be centrally as sources of instability, days — volatility evident cleared. That requirement CCPs are required to have in large daily variation and similar regulations robust risk-management margin payments (see internationally mean central procedures that protect Figure 78). These defaults counterparties (CCPs) against the potential failure were covered either by the have become central to of one or more members. member’s initial margin swap markets globally by or, in the case of client standing between buyers Margin provides a buffer defaults, by the responsible and sellers in order to to protect a CCP against clearing member. Initial margins were significantly Figure 78. Margins Required by CCPs Jumped in Early raised to protect against the 2020 ($ billions) repercussions of additional defaults. 2,000 Initial margin (left axis) 250 Maximum daily variation margin (right axis) 1,600 200 Average daily variation margin (right axis)
1,200 150
800 100
400 50
0 0 Jun Jun Jun Jun Jun 2016 2017 2018 2019 2020
Note: Data as of June 30, 2020. Quarterly aggregate sum of global central counterparty (CCP) margins.
Sources: Clarus CCPView, Office of Financial Research
96 OFR ANNUAL REPORT TO CONGRESS 2020 MAPPING INTERCONNECTIONS AMONG CENTRAL COUNTERPARTIES
As one way to monitor contagion risk, OFR researchers have studied and mapped connections among central counterparties. Even though CCPs have several layers of protection against potential default by one or more members, risks remain. For example, in September 2018 Nasdaq Clearing came close to using all of its prefunded default waterfall resources to cover very large multiday losses by one Norwegian trader, Einar Aas, on his position in electricity futures
Figure 79. Mapping Shows Central Counterparty (CCP) Connections
TMX ASX B3 TAIFEX CME TADAWUL COMDER CRCCC SHCH DTC SGX SAFCOM EUREX OTC Clearing FICC Hong Kong OCC ICCL N2X CLEARING ICE CLEAR CREDIT NSCCL - ICE CLEAR settling banks EUROPE - CDS NCCPL - ICE CLEAR settling banks EUROPE - ENDEX NASDAQ ICE CLEAR NORDIC EQUITIES EUROPE - IFEU MGEX ICE CLEAR EUROPE - IFUS LCH SA ICE CLEAR NETHERLANDS LCH Ltd. ICE CLEAR SINGAPORE KPEI ICE CLEAR US KORW JSCC-IRS INDIA ICC CCP
Note: The thickness of each line represents the number of members each pair of CCPs have in common. The size of each circle represents the number of clearing members a CCP has as of the first quarter of 2020. The color of each circle represents the CCP’s location: blue is North and South America, orange is Europe, and green is Asia.
Source: Office of Financial Research
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 97 contracts. The losses in excess of initial margin were so large that the CCP’s prefunded guarantee resources were substantially depleted.95 This incident was a “close call” rather than an example of contagion, and it did not involve a large member. However, the incident highlights the potential risks posed by CCPs in the international financial markets. If a CCP were to default, or the member had defaulted at several CCPs, there could be substantial contagion effects due to interlocking memberships and loss spillovers on members’ balance sheets.
Contagion between CCPs can be transmitted through a variety of channels. Suppose that some member M of one CCP defaults because it cannot meet its margin obligations on a particular day. Then the CPP will close out M’s positions. Depending on the concentration of M’s positions in particular markets, there will be some degree of price impact. This price impact may lead to margin calls by other members of the same CCP as well as members of different CCPs that clear the same markets, which in turn can lead to additional member defaults. Defaults by other members can occur even though the CPP itself does not default.
If the CPP does default, then the usual arrangement is that it haircuts the payments owed to all its members. Thus all members of the CCP are subjected to a negative shock, a second channel that could cause them to default to other CCPs of which they are members. There is a third channel of contagion: if member M defaults at the CPP, then it will typically be declared in default at all the CCPs of which it is a member, due to cross-default agreements.
The more members two CCPs have in common, the more likely it is the two CCPs will suffer a simultaneous default. OFR researchers’ maps make such linkages visible (see Figure 79). In Figure 79, the thickness of each line represents the number of members each pair of CCPs have in common. On this measure, there is an enormous amount of interconnectedness between CCPs across the globe.
CYBERSECURITY RISK and their potential and the interdependencies consequences for the between firms that result The U.S. financial services operational resilience of from the connections sector is at risk of a material financial firms and the needed to carry out these cyber incident, one that stability of the U.S. financial processes, introduces is significant enough to system. significant cyber present systemic risk. In vulnerabilities. Financial The use of information this context, cybersecurity institutions often rely on technology to execute risk is a product of cyber each other to provide critical financial processes, vulnerabilities and threats, critical operations. The
98 OFR ANNUAL REPORT TO CONGRESS 2020 many links between concerns. A cyber incident increases the risk that a networks, technologies, could compromise the cybersecurity event will and data supporting integrity of information have severe negative these operations can technology systems and consequences. Firms create or magnify cyber data that are critical to continue to invest in vulnerabilities, threatening the stable functioning of information technology the operations of not just financial firms, operations, to increase the efficiency individual institutions, but and the system as a whole. of and to enhance and also the financial system. This, in turn, could trigger expand their services, cascading effects, due to including cloud computing At the same time, the contagion or concentration to support mobile U.S. financial system risks, or a combination banking, and artificial faces cyber threats from a thereof. Furthermore, such intelligence and machine growing range of malicious a situation could lead to a learning to improve fraud actors, including criminals, loss of confidence among detection. However, these insiders, nation-states, and customers and market technologies can introduce hacktivists. Cyber criminals participants, resulting new cyber vulnerabilities represent pervasive and in destabilizing asset into the financial system’s costly threats, with credit withdrawals or market sell- critical infrastructure. card fraud and account offs. manipulation, for example, Additionally, supply chain costing firms billions of FINANCIAL SERVICES dependencies can pose dollars in losses. Insiders, SECTOR USE OF cyber vulnerabilities. In the typically employees or context of cybersecurity, INFORMATION contractors, possess access the supply chain is to firms’ networks and TECHNOLOGY defined as the global system privileges. Certain network of information Despite significant nation-states threaten to and communications investment in cybersecurity, disrupt or interfere with technology suppliers and financial system cyber the U.S. financial system service providers that vulnerabilities persist. via cyber attacks, money financial institutions rely If exploited, those laundering, and ongoing on to support and execute vulnerabilities could espionage. In addition, their business operations.96 result in a material cyber hacktivists may target the In particular, firms rely on incident that may affect sector to address their foreign-made computers, the operational resilience ideological grievances and network devices, and of financial institutions or advance a political agenda. related equipment, which increase systemic risk. creates the potential for Nonetheless, there have not nation-state actors to The increasing reliance yet been cyber incidents influence the financial of financial firms on with severe systemic system supply chain. information technology, impacts. However, material particularly across cyber incidents may interconnected platforms, present financial stability
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 99 CYBER CONTAGION at a financial institution vulnerabilities arise from AND CONCENTRATION providing key services for financial institutions’ RISKS other firms could cause reliance on systems or significant operational assets that are owned or The reliance on an disruptions to the sector. operated by third parties 98 increasingly complex and This issue is particularly from other sectors. interconnected information acute when participants Maintaining confidence technology infrastructure provide services of systemic in the security practices exposes the financial importance for significant of these providers is services sector to contagion firms. increasingly important to and concentration risks. A preserving stability and Moreover, the financial cyber incident that exploits preventing contagion. sector faces cyber risks as one or both of these a result of dependencies Although financial risks could have severe financial institutions have institutions’ use of, and consequences for the entire on companies in other dependencies on, third system. sectors.97 The financial parties allows the financial First, contagion risk services sector depends on system to function results from the cyber energy and communications efficiently and to offer an vulnerabilities inherent sectors to provide the expansive array of products in the connections electricity and Internet and services, it also results between firms and connectivity that enable in a loss of direct control across the system. Cyber financial processes. Cyber over the cyber risks to vulnerabilities may arise incidents affecting this which these third parties from interdependencies, critical infrastructure could are subject. In this context, such as the key transactions have serious adverse effects dependency refers to and processes that financial on the operations of the the reliance of a financial institutions enable on U.S. financial system. For institution or market utility behalf of one another. example, a cyber incident on a system, application, Connectedness among firms resulting in an electricity or asset. When a third may give rise not only to outage in the northeastern party owns and operates credit and liquidity risks, United States could affect a system, application, or but also to operational risk. the U.S. financial hub of asset on which a financial Linkages with operational New York City. institution depends, that importance include access third party may pose Critical vendors may pose to the systems that allow cyber, and more broadly, cyber vulnerabilities to for payment, clearing, operational risks to the financial institutions as well and settlement systems to financial institution. Third- as to the financial system operate smoothly. These party dependencies involve due to the potential for linkages increase efficiency some degree of a loss of contagion risk, undermining but may magnify cyber control, as “outsourcing business continuity and vulnerabilities. For example, inherently means that the incident recovery capacity. a cyber incident that occurs organization depends on Financial system cyber
100 OFR ANNUAL REPORT TO CONGRESS 2020 external entities that may For example, most major risk to the firm — even not share its approach to U.S. financial institutions use if the firm does not have resilience and cybersecurity cloud computing services. any direct contractual or which may have a Several large technology- relationships with it. More different level of security focused firms have been broadly, if enough financial capability.”99 A third-party central to the development institutions rely on that data provider may not fully of cloud computing and the center — either directly or understand the level of growth of the public cloud indirectly — the data center dependence that a financial market. To achieve the scale could pose system-wide institution, or the sector, has necessary to maximize the concentration risk. on the vendor’s operations potential of this technology and may not mitigate risks requires substantial EMERGING QUANTUM to the level that a financial resources. Thus, a small COMPUTING RISK institution needs. number of cloud computing providers dominate the Quantum computing is Further, if enough firms market, which in turn an emerging technology rely on the same third- increases concentration that has the potential to party service providers or risk. A cyber incident at one become a new source products, either directly provider could negatively of cybersecurity risk. A or indirectly, that could affect many financial quantum computer uses create a concentration services sector customers. the unusual characteristics of cyber risk. A single of quantum mechanics — financial institution may use The concept of fourth- the nonintuitive behavior hundreds or thousands of party risk, which arises of very small particles — third parties, with varying through subcontracting to perform computation levels of service criticality, by third parties, further on an exponentially connectivity to firm systems, complicates the calculation larger scale than what is and access to sensitive of concentration risk posed possible today.101 Quantum 100 firm data. Within this set by critical vendors. As computing could not of third parties, such a an example, a third party only increase calculating financial institution could technology service provider power, but also change also depend on another hired by a firm to process it in ways not currently subset of critical vendors, or data may store those data possible. Today’s encryption those third parties that the in a data center; the data keys used to safeguard financial institution deems center is a third party to the financial transactions could critical to its business technology service provider, be cracked within a few operations, based on the and a fourth party to the hours if the technology services performed or the financial institution. In such were available now. While products provided. Potential a scenario, if many of the predictions vary, quantum concentration risks may firm’s third-party service computers capable of arise when multiple financial providers use the same breaking today’s keys are institutions rely on the same data center, this data center estimated to be about 15 critical vendors. may pose concentration years away.102
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 101 The exposure of private threats and vulnerabilities • Legacy contracts without information contained continue to grow, both in appropriate fallback within financial transactions volume and sophistication. provisions for when is a potential threat to Financial firms are primarily LIBOR reference rates financial stability because responsible for their cease remain a source such exposure could own security, but the of risk for the parties conceivably severely disrupt U.S. government, led by involved. trust in the financial system. Treasury, works closely with • The COVID-19 pandemic To thwart the threat from firms on risk mitigation exacerbates risks this emerging technology, efforts, information associated with the new encryption methods sharing, and incident United Kingdom’s exit must be standardized and response planning. The from the European deployed beforehand. better prepared the U.S. Union. Multiple approaches to government and the private post-quantum cryptography sector are in advance of a have been developed cyber incident, the better NATURAL DISASTERS through research. The able the financial services Natural disasters are a federal government is sector will be to weather a source of uncertainty with coordinating its quantum material cyber incident and potentially large, local or research and development limit its systemic impacts. regional humanitarian and efforts through the economic costs. Naturally Subcommittee on Quantum ADDITIONAL RISKS occurring events include Information Science within weather events such as the National Science Additional risks to financial hurricanes, hail storms, and Technology Council. stability come from changes and tornadoes; geological Standard protocols for post- to the financial system events such as earthquakes; quantum cryptography are operating environment. floods; and wildfires. In expected to be drafted and There is uncertainty about 2017 and 2018, wildfires released within the next five the magnitude of the caused numerous deaths years. However, adoption of economic and financial and extensive physical these new protocols could consequences and the and economic damage extend into the mid-2030s potential for these changes especially in California. or later. to be disorderly. We While 2019 was relatively highlight progress and calm, wildfires were again a IMPROVING FINANCIAL concerns in three areas this major source of economic SYSTEM CYBERSECURITY year: damage in 2020 and remain an economic threat.103 Although participants • The COVID-19 pandemic in the financial services adds to concerns about It is argued that extreme sector continue to invest in the costs of natural weather events could cybersecurity and improve disasters. become more common the resilience of networks as a result of changes to and systems, cyber the global climate during
102 OFR ANNUAL REPORT TO CONGRESS 2020 this century. The potential “The earth has suffered Longer term, the issue costs and economic mass volcanic explosions, is the implementation consequences of climate flooding, meteor impacts, of an economic support change issues remain a mountain building and all mechanism should another subject of debate among manner of abuses greater pandemic occur. researchers.104 According than anything people could to the Financial Stability inflict, and it’s still here … There have been Board (FSB), 24 financial the earth doesn’t care.”106 suggestions for the authorities around the Another suggestion is that adoption of a formal world consider, or plan to increased economic costs of federally backed pandemic consider, climate-related natural disasters also reflect support program using an physical or transition risk “people … flocking to insurance framework, similar as part of their financial disaster prone regions.”107 to those in use for covering stability monitoring.105 California seems a good flood and terrorism risks.109 Most focus on possible example. changes in asset prices and TRANSITION FROM credit quality. Some also If one would consider LIBOR TO ALTERNATIVE consider the implications for the COVID-19 pandemic REFERENCE RATES underwriting, legal, liability, to be a type of natural and operational risks. The disaster, it is one that has LIBOR, formerly the Bank of England will include had a global impact on London Interbank Offered “exploratory” climate economic and financial Rate, is a set of globally change scenarios in its 2021 stability. Few sectors have used reference rates, or bank stress test tests. been spared, although benchmarks, that determine some have profited largely. interest rates for borrowing Challenges to quantifying Most types of insurers have in different currencies and such risks persist, according been directly affected, for different amounts of to the FSB. some favorably (health time. LIBOR, including and automobile insurance) U.S. dollar LIBOR, are The Bank of England’s and some unfavorably determined from reports Prudential Regulation (workers’ compensation by a panel of banks of Authority included a climate insurance, and travel and their costs of unsecured 108 change scenario in its event insurance). The wholesale borrowing. 2019 insurance stress test. most important insurance The frequency and cost issues are short-term and LIBOR no longer of natural disasters are of long-term implications accurately reflects the obvious importance to the for business interruption marginal borrowing costs insurance business, and of insurance coverages. of major banks. As the course, well recognized by Over the short term, volume of transactions the industry. there will be extensive that underpinned LIBOR litigation regarding the diminished, regulators, One scientist provided this scope of existing business coordinated through the very long-term perspective interruption coverages. FSB, began a multiyear on natural disasters:
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 103 transition to reference the LIBOR panel, leaving Rates Committee has rates based on observable too few submitting banks proposed New York State transactions in active that are sufficiently active in legislation to modify certain markets. This process the relevant markets for the contracts referencing accelerated when some rate to be representative of LIBOR and create a “safe banks ceased to report data those markets.110 harbor” for parties that used to calculate LIBOR. rely on the recommended In June 2020, the FCA benchmark as a fallback In the United States, the announced that it would be considered.112 This Alternative Reference seek additional powers to legislation would affect only Rates Committee chose manage the wind down of contracts governed by New the Secured Overnight LIBOR. Further, the FCA York law and its passage is Financing Rate (SOFR) as its said that announcements uncertain. recommended alternative could come as early as to U.S. dollar LIBOR. this year that some LIBOR SOFR-linked financial The committee includes would either cease or contract volume is growing banks, asset managers, become non-representative rapidly, but remains small insurers, and industry trade as of the end of 2021, and in comparison to LIBOR- organizations as well as thus ineligible for use in linked volume. There are federal and state financial many contracts after the about $200 trillion in U.S. regulators as ex-officio end of 2021. The FCA is dollar LIBOR-linked financial members. In cooperation seeking powers to create contracts outstanding, with the Federal Reserve “synthetic” LIBOR for use which is about 100 times Bank of New York, the OFR in legacy products to help the amount of financial helped to develop, oversee, manage the transition contracts that are SOFR- and ensure a source of data to new rates after given linked.113 to support SOFR. LIBOR are declared non- representative. These SOFR is a single overnight The U.K.’s Financial “synthetic” LIBOR rates reference rate that does Conduct Authority (FCA) could expose U.S. contract not account for variations regulates LIBOR. The parties to legal risk and in credit risk. It also does FCA secured voluntary uncertainty.111 not reflect a term structure, agreement from banks that because it is solely an are LIBOR panel submitters There will probably still be overnight rate, although to continue reporting rates contracts that reference averages of SOFR over through the end of 2021, LIBOR without adequate defined periods can be but will not compel banks fallback provisions after used. In the view of some to submit after that time. As LIBOR publication ends. market participants, both a result, after 2021, some These financial contracts credit and term structure LIBOR rates may cease or will expose the parties are needed elements of become non-representative. involved to legal and a reference rate system. A LIBOR is non- operational risks. For Regional banks met with representative if some, but these contracts, the federal banking regulators not all, banks withdraw from Alternative Reference on Feb. 25, 2020, to discuss
104 OFR ANNUAL REPORT TO CONGRESS 2020 ways to link loan products a trade deal, then U.K.- contingency plans assuming such as commercial real EU trade will revert to the transition period is not estate mortgages and World Trade Organization extended past December commercial and industrial rules. Lawmakers in the EU 31.117 loans to reference rates and the U.K. have made that include a credit risk progress in mitigating The combined shock of component.114 Following up the impact Brexit will the COVID-19 pandemic on this meeting, the Federal have on financial markets and an exit without a trade Reserve Bank of New York through several transition deal could be damaging has hosted regular Credit concessions, including for the EU, the U.K., and Sensitivity Group workshops permission for EU firms to potentially the United to address this area.115 operate in the U.K. until States. The shock could March 2023. Uncertainty manifest in decreased Several other alternatives to remains, though, economic output; inefficient LIBOR have been discussed. particularly with respect to financial markets burdened These include Ameribor, the lack of “passporting” by multiple regulatory Tradeweb/ICE, and others. between the U.K. and frameworks; or reduced EU. Passporting allows movement of people, U.K. EXIT FROM THE firms from EU nations to goods, and services. EUROPEAN UNION sell services across the EU without having to The United Kingdom comply with each country’s formally left the European separate regulations or Union on Jan. 31, 2020, having to have subsidiaries beginning a transition that to conduct business in is due to end December 31. certain jurisdictions. Lack During the year, the U.K. of passporting threatens has essentially continued established contractual to be treated as a member agreements. The United while the two sides States could be affected negotiate the details of the because the U.K. would split. become a third party to EU- U.S. agreements. The uncertainty and risks associated with Brexit were Financial firms have been highlighted in the OFR migrating assets and 2019 Annual Report.116 employees from the U.K. Given the lower priority of to several EU countries in Brexit negotiations since anticipation of Brexit. The the onset of the pandemic, European Securities and these uncertainties and Markets Authority in July risks have grown. If the urged financial market two sides fail to agree to participants to complete
PART TWO: ASSESSING FINANCIAL RISKS AND UNCERTAINTY 105
PART THREE: EXPLORATION OF INFORMATION MARKETS
PART THREE: EXPLORATION OF INFORMATION MARKETS118
Earlier sections of this of vulnerabilities (which more accurate and timely report highlight the tends to rely on a naturally signals of weakening difficulty for conventional limited handful of research financial stability.121 financial stability monitoring and data insights) with to timely and accurately insights from people who Another prominent set of identify true vulnerabilities. are most knowledgeable authors from the California Invariably, any such process about where and when Institute of Technology, the of identification is prone to those vulnerabilities University of Pennsylvania’s finding vulnerabilities that might reveal themselves. Wharton School, and turn out to be immaterial A mechanism for doing Dartmouth College or nonexistent, as well so might lie with better characterized prediction as missing vulnerabilities developed “prediction” markets as capable of that are fundamentally or “information” markets, quickly assessing new difficult to anticipate where people who have information, and robust to before the fact, such as superior information about manipulation.122 Prediction those associated with the answering consequential markets might do so by COVID-19 crisis. On this questions can have leveraging the self-selection latter point, for example, no relatively strong incentives of market participants — conventional annual stability to share their insights more that is, participants who report flagged the potential freely. are better informed about for pandemic as a threat to a particular question are financial stability this year.119 Led by a Nobel prize- more likely to correctly winning economist, answer the question and While crystal ball forecasts authors of an article in the thus enjoy a monetary of systemic vulnerabilities journal Science argued payoff for having done or crises have proven that “such markets can so. And the converse is infeasible, financial stability help to produce forecasts also true — that is, people reports remain valuable. of event outcomes with a with inferior information They may have potential lower prediction error than could participate, but find to become more valuable conventional forecasting themselves more often than still by complementing methods.”120 Moreover, not losing money, and thus information produced by such markets have been have relatively weak voice in conventional monitoring shown capable of producing the wisdom of crowds.
PART THREE: EXPLORATION OF INFORMATION MARKETS 109 This section of our report evaluate whether proposed might also increase as their thus begins with a review or enacted policies and asset holdings become of how costly or otherwise regulations can reduce more “correlated.” If A and hidden information can systemic risks in a cost- B are both heavily invested play a fundamental role in effective manner.124 This in housing securities, for creating systemic risks, and latter type of market might example, then their risks of illustrates how a market also help point the way insolvency can increase at might economize on those toward less distortionary the same time with falling costs. Current approaches and more effective housing prices. to managing systemic stability-related policies risks rely to a considerable and regulations.125 And Finally, Banks A and B extent on regulation, ultimately, mechanisms such might fail in close order capital requirements, and as these could be important through the dynamics of oversight. People who for the real economy, “contagion.” Normally, are charged with enacting where reliably expanding depositors and other short- these strategies, however, opportunity depends in term, fixed-claim lenders may work at a considerable considerable part on a can rationally remain distance from local reliably free flow of financial ignorant about each bank’s knowledge that can help capital.126 asset holdings (because gauge reliance of financiers they are among the first in a line of claimants to be on each other for funding, THE ROOTS OF the concentration of asset paid back). The prospect holdings across financiers, SYSTEMIC RISK of B failing, however, can and the likelihood that increase the sensitivity of adverse news about one In 2014, the Committee on A’s creditors to information financier’s solvency can Capital Markets Regulation that they would have encourage runs on another’s offered a useful taxonomy rationally ignored in normal liabilities. Top-down for examining the roots of times. And rather than bear approaches to monitoring systemic risk.127 Systemic risk the cost of collecting that and managing systemic might emerge from any one information on news of B’s risk can thus face tight and of the “three C’s” — that is, difficulties, these creditors hard-to-move constraints connectedness, correlation, may do better by quickly against efficiently reducing or contagion (see Figure withdrawing their financial the possibility, and 80). For example, Bank A support, which in turn could mitigating the severity, of can become “connected” instigate a run on Bank A. any such future crisis. to Bank B through its loans to B. The prospect of B It is important to appreciate A market for information failing prior to repayment, how the foundation from about the prospects for in this case, could increase which each of the “Three realizing systemic risks could concerns about A’s solvency. C’s” might increase address such constraints.123 systemic risks shares a Information markets might The chance for Banks A common factor — that is, also be structured to better and B to fail in close order the opportunity cost of becoming fully informed.
110 OFR ANNUAL REPORT TO CONGRESS 2020 For example, if information Figure 80. The Three C’s of Systemic Risk was costless, then Bank A’s creditors would know Connectedness exactly how “connected” their investments are to T Bank B’s performance, and A exactly how healthy B is and will be. And except for transaction costs, the prices at which A could attract Bank A Bank B financial backing would A fully reflect this information at all times, leaving A’s creditors indifferent Correlation between maintaining and withdrawing their support. Except for information costs in this model, A’s creditors would have little incentive F to “run” on the prospect Bank A Bank B of a “connected” bank’s difficulty.
Likewise, equipped with full information, creditors of Banks A and B would know exactly how “correlated” Asset Class their investments are to any particular asset or class, and prices at which those banks Contagion could attract capital would fully reflect that information. Investors in both banks T would have relatively little reason to run, because A doing so in expectation would get them no more Bank A Bank B than foregoing withdrawals until later.128 Source: Office of Financial Research Finally, “contagion” may find difficulty gaining a toehold without costly information. Normally,
PART THREE: EXPLORATION OF INFORMATION MARKETS 111 short-term, fixed-claim on information that can structures and institutions investors in Banks A and become stale. Policies that that reveal who benefits B can rationally maintain address contagion face the from an exchange of ignorance about their same constraint, and the goods or services, facilitate banks’ asset holdings. In widespread policy of basing terms for the exchange, this state of the world, capital requirements on and economize on the longer term and contingent asset holdings might even opportunity costs of capital has to lose increase risk by encouraging enforcing those terms, are considerable value before financial organizations necessary for allocative these short-term fixed to correlate their asset efficiency that expands claims are compromised. holdings.130 All might do economic opportunity The opportunity for such better if information about at any point in time, and investors to quickly and the prospect of realizing for productivity gains fully exit in normal times systemic risks could be that expand economic can rationally discourage produced at a lower cost. opportunity across them from monitoring time. To the extent that banks’ asset holdings.129 Competitive markets systemic risks grow from In a manner similar to for information about the deep root of costly that of the first two “C’s,” systemic risk could facilitate information, market costless information would this efficiency gain. The structures and institutions leave Bank A’s claimants late Nobel laureate, that economize on those indifferent to running on Ronald Coase, reminded aspects of transaction costs the news that B’s chance economists that political might complement more of insolvency increased. and legal institutions are centralized approaches Rather than being a discrete superfluous, except for to strengthening financial surprise, that prospect obstacles to mutually stability. would be known and beneficial transactions such as the cost of becoming competitively priced at all HOW INFORMATION times. sufficiently informed about the quality of a product or MARKETS MIGHT Seeing through this service. To be sure, Coase’s COMPLEMENT taxonomy to a necessary point was not that markets SYSTEMIC RISK condition for systemic naturally evolve to their risk could help improve competitive ideal. Rather, MANAGEMENT management of that risk. it was to highlight what Nevertheless, conventional human-made organizations Information markets can policy approaches to must do to create the serve as a platform for addressing connections conditions for Adam Smith’s trading securities, the between banks or “invisible hand,” and thus payoffs of which refer to correlations across banks’ reliably expand economic whether a particular state- asset holdings rely on opportunity. of-the-world is realized second-hand or more on a certain date. Such distant information or Viewed through this a security might refer to Coasean lens, organizational
112 OFR ANNUAL REPORT TO CONGRESS 2020 an indicator of systemic conditions for triggering consumption activities risk, for example, and that realization, is likely to might have otherwise promise to pay its owner systematically lose money in appeared independent $1 if that measure exceeds such a market. Traders who of how well the financial a particular threshold 90 buy and sell information services sector was days into the future. To market securities based on performing. the extent that market what they prefer to happen institutions in which that (rather than what they A realization of systemic security trades promote believe will happen) could risk through any of the pricing efficiency, security be similarly disadvantaged. “three C’s” (connectedness, prices throughout the Even if such individuals correlation, or contagion) contract period could offer enter a market, they may could imply that the a real-time and unbiased have only a weak effect on relatively independent estimate of how likely the the price at which a security performance of financial threshold will be realized trades, leaving the best service organizations in on the expiration date. If informed and least biased normal times can become the security trades at $0.25 traders to influence prices. much more strongly related. on day 60, for example, An economic laureate, then even individuals who Except for its importance Myron Scholes, similarly are not participating in the to general economic noted that “at times of market could learn that performance, the potential [financial system] crisis, the specified indicator of for widespread failure of things that were seemingly systemic risk is expected financial service firms might unrelated all of a sudden to have been breached 30 well receive less attention become related.”134 A days out with a 25 percent than does systemic risk.133 research team (Beville, chance.131 In other words, if downturns Falaschetti, and Orlando in the financial services (2010)) built on observations Markets such as these can sector tended to be self- such as these to consider be efficient, and frequently contained, then producers what an information market outperform competing and consumers outside the for systemic risk might mechanisms such as polls sector might worry much look like, and how it might for aggregating otherwise less about the prospect for complement or substitute dispersed information.132 systemic crises. The breadth for various aspects of more This empirical efficiency of economic decline centralized approaches to can make sense from a associated with 2008’s managing that risk. They theoretical perspective. Financial Panic may suggest did so by noting that, Note, for example, otherwise, however — that while the performance of that someone who is is, the Great Recession and financially dependent and relatively ignorant about previous financial recessions independent firms might what is necessary for a had a strong impact on share little correlation hypothesized state of the a broad distribution of during periods of relatively world to actually occur, or firms and households low systemic risk levels, the evolution of empirical whose production and that relationship could
PART THREE: EXPLORATION OF INFORMATION MARKETS 113 grow in strength under the pharmaceuticals. When such correlations having hypothesis that difficulties prospects for systemic risk reached a particular in the financial services are increasing, however, threshold on a future date, sector can trigger a broader business performance in might efficiently predict economic downturn.135 these two sectors might whether this indicator of become more strongly systemic risk will indeed In this model, an increase aligned. be realized. Broad access in the correlation between to those predictions could, the performance of Building on these in turn, help investors and financially dependent and relationships, researchers regulators better monitor independent firms might found that daily stock channels for financial offer information about market returns from what contagion and reallocate the prospect of realizing can otherwise appear to be resources according to systemic risks, and thus very different types of firms this information in a more serve as a payoff trigger began to exhibit historically orderly manner than would for information market strong correlations in the after-the-fact bank runs. contracts.136 To illustrate third quarter of 2007, The authors highlighted, how such a contract might and continued to do so for example, that this type work in practice, the same through the first quarter of of market indicator might research team (Beville, 2009.137 The authors also have raised red flags well Falaschetti, and Orlando corroborated this statistical in advance of the Panic of (2010)) looked to peer evidence by analyzing texts 2008, as the correlation reviewed estimates (Rajan from financial news, and between tobacco and and Zingales (1998)) for were unable to dispose pharmaceutical stocks information about how of the conclusion that the almost tripled from 0.27 in sensitive firms are in increased correlation in the middle of 2007 to 0.75 various economic sectors their data reflects elevated as the Panic played out. to the efficiency with which systemic risk per se, and not financial services are being some unrelated force. These authors also produced. These estimates suggested that, by suggest that pharmaceutical Finally, these researchers economizing on the costs firms tend to be most detailed how an information of anticipating systemic reliant on financial service market contract that risks, information markets efficiency, and tobacco derives from stock price might facilitate a more firms the least. In normal correlations between suitable allocation of those times, we might thus financially dependent and risks, and thus reduce expect the performance of independent firms might the chance for systemic pharmaceutical and tobacco provide an early warning to crises to emerge while firms to be influenced systemic risk regulators and increasing the resilience by largely unrelated market participants alike. In of financial markets in the forces — for example, particular, they highlighted event of such a crisis. While weather for tobacco and how prices for information addressing how information the pace of discovery for market securities, where markets could strengthen payoffs are contingent on
114 OFR ANNUAL REPORT TO CONGRESS 2020 the ability of regulators, distributional interests, counterparties, and third markets such as these could parties alike to improve risk improve both public and management for a given private management of institutional structure, this systemic risk by serving as a research left untouched the complement to regulations question of how information and oversight institutions. markets might also improve forecasting abilities for the regulatory landscape. Others (Abramowicz (2004)) showed how such a market could also be constructed.138
Effectively managing systemic risk is important if financial institutions and markets are to reliably support economic opportunity, while also serving as a moderator of economic fluctuations. Consider, for example, that apps on today’s smart phones come with little if any marginal increase in consumer prices, but would have cost almost a million dollars in the 1980s.139 Absent a relatively free flow of financial capital, productivity gains that facilitated this remarkably fast and large increase in consumer surplus may not have been possible.140
Information markets for systemic risk might find an important supporting role here. By discouraging participation from people with weak information or
PART THREE: EXPLORATION OF INFORMATION MARKETS 115
PART FOUR: THE OFR’S PERFORMANCE
PART FOUR: THE OFR’S PERFORMANCE
A YEAR OF MISSION flexible and responsive to employee engagement and FOCUS its stakeholders’ changing efficiency. needs in a disciplined manner as financial markets Congress established the INTERNATIONAL and business models OFR principally to support evolve. Consistent with LEADERSHIP IN the Financial Stability organizational excellence, CROSS-BORDER Oversight Council by the plan fully aligns with the providing germane data to FINANCIAL DATA Treasury Department’s FY FSOC members, developing 2018-2022 Strategic Plan. STANDARDS empirically supported research insights, and STEADY PROGRESS GREATER ADOPTION advancing data products OF THE LEGAL ENTITY that can point to financial The past year saw OFR IDENTIFIER (LEI) BY system vulnerabilities. make great progress in fully Adhering to and delivering engaging staff members GOVERNMENTS AND on our Office’s statutory in truly consequential THE PRIVATE SECTOR mandate was essential to work. OFR colleagues identifying and assessing embraced leadership The LEI is a data standard those vulnerabilities in a roles in both national and for precisely identifying year that saw considerable global committees and parties to a financial turbulence threaten organizations. They also transaction. The OFR financial stability. built vital databases from continues to play a concept to final products, leadership role in the LEI A NEW STRATEGIC PLAN as well as timely shock- Regulatory Oversight and-stress-indicators, and Committee (ROC). The This year also saw the OFR reliable stability and risk ROC is an international complete its fiscal year monitors. And furthering group of public sector (FY) 2020-2024 Strategic its pursuit of organizational authorities instrumental Plan. Rooted in the Dodd- excellence, OFR established in establishing the Global Frank Act, with a firm a culture of accountability LEI System, and acts as a emphasis on our Office’s and professionalism governance body for the mandate to support the at every level of our Global LEI Foundation. This FSOC and its members, our organization, which led to private, nonprofit entity sets plan allows the OFR to be fulfilling improvements in standards for the LEI and
PART FOUR: THE OFR’S PERFORMANCE 119 oversees adherence to those precisely identify parties in regarding their “direct standards by companies transactions, it is also being accounting consolidating and organizations that issue considered as an element to parent” and the “ultimate LEIs. identify parties involved in accounting consolidating cross-border payments and parent” — that is, the Use of the LEI is growing, in export-import financing. ultimate owner of the both in the United States entity. With access to and abroad. With more The OFR plays an integral such data, participants in than 1.7 million LEIs issued role in maintaining a transaction can quickly as of Sept. 30, 2020, the ISO 17442, a standard identify the parents of their Global LEI System has developed by the counterparties, as well as already achieved its goal of International Organization subsidiaries or other entities establishing the preeminent, for Standardization (ISO) within an organization, and high-quality entity identifier on which the LEI is based. thus better control their risk. for nearly every systemically This year, ISO completed important and globally a five-year review of ISO ESTABLISHMENT OF active financial firm. 17742 and published an NEW CROSS-BORDER updated version. OFR staff FINANCIAL DATA The LEI lets government participated in domestic financial authorities quickly and international working STANDARDS and accurately identify groups that contributed to This past year, the ROC took counterparties to financial this review. As members on the role of international transactions, and in doing of these working groups, governance for three new so, allows for more accurate they provided leadership, financial data standards: and cost-effective analyses contributed to the the Unique Transaction of emerging risks to national development of documents, Identifier (UTI), the Unique financial systems, especially and applied subject matter Product Identifier (UPI), where these risks may cross expertise. national borders. At the and the Critical Data same time, private firms IMPROVED LEI DATA Elements (CDE), that will facilitate the global may employ the LEI to QUALITY better monitor their own risk aggregation of over-the- counter (OTC) derivatives positions. The ROC has continued data. The OFR, as chair to focus on improving the of the ROC’s Working The growing use of the quality of data that underlie Group on Governance LEI over the years has led the LEI, including expanding of Unique Identifiers and to its adoption outside of its work on strengthening Data Elements (GUIDE), its roots in counterparty the standards for Level 2 LEI collaborates with the risk management and data and other elements of Financial Stability Board’s the financial sector. For LEI reference data. example, the LEI can reduce Working Group on UTI costs for banks when Entities obtaining an LEI and UPI Governance (FSB they bring on new clients. submit Level 2 LEI data GUUG). And because the LEI can
120 OFR ANNUAL REPORT TO CONGRESS 2020 The UTI is a new global the OFR participated in Consolidating governance financial data identifier finalizing the technical and of these new financial that uniquely identifies an governance arrangements data standards under the OTC derivatives financial with the Association of ROC leverages the ROC’s transaction. A key milestone National Numbering experience in governing was achieved this year, Agencies (ANNA) Derivative the LEI. The OFR will with the OFR’s input and Service Bureau (DSB), the continue working with support, for the FSB GUUG Service Provider for the FSOC members and non- to approve and hand off the UPI. The ANNA DSB’s role U.S. regulatory authorities UTI to ISO for development is to issue UPIs, as well as to support the ROC’s of the UTI as an approved manage the UPI repository. governance of the UTI, UPI, ISO standard. With direct and CDE, while maintaining input from the OFR in The CDE for OTC the ROC’s robust oversight the ISO Working Group, derivatives transaction of and commitment to the the analysis of the new reporting harmonizes how Global LEI System. standard (ISO 23897) was certain data are reported to regulators and trade completed, and the UTI is DATA PRODUCTS now available for industry repositories. This standard use. The UTI will be used has many potential benefits, AND INNOVATIONS in multiple jurisdictions including the quality of and improves the abilities data that regulators, trade The Dodd-Frank Act of firms to monitor their repositories, and firms requires OFR to develop OTC derivatives financial collect about financial tools for measuring and transactions across borders. transactions. In 2020, monitoring financial the OFR continued its vulnerabilities and risks. In The UPI will allow participation in the FSB this fiscal year, those tools derivatives regulators GUUG’s CDE Message included the start of the and other government Group, where the group Office’s first data collection, agencies to better monitor completed its analysis which covers centrally emerging financial risks by of the CDE data. This cleared funding transactions categorizing different types work was conducted in in the U.S. repurchase of derivatives transactions. partnership with the Society agreement (repo) market A second milestone for for Worldwide Interbank (see U.S. Repo Markets Data the FSB GUUG, with Financial Telecommunication Release and the Short-term contributions from the OFR, (SWIFT), the Registration Funding Monitor). The OFR is the initial development of Authority for the ISO 20022 addresses its Congressional the UPI as an ISO standard. standard, with the OFR mandate through this The OFR participated in providing subject matter collection and a number the ISO Working Group, expertise. The CDE data will of other germane data which expects to deliver be incorporated into the products, which we review two documents from the ISO 20022 repository and below. assessment phase by year- available for industry use end 2020. Additionally, early next year.
PART FOUR: THE OFR’S PERFORMANCE 121 U.S. REPO MARKETS DATA RELEASE AND THE SHORT-TERM FUNDING MONITOR (STFM)
Short-term funding is crucial for price discovery, efficiency, and liquidity in securities markets. Short-term funding markets provide financing, facilitate hedging of risk, monetize liquid assets, serve as a low-risk alternative to deposits for cash investors, and can be used to obtain securities. These critical markets are vulnerable to disruptions, and stresses in short-term funding markets can signal problems in the financial system. To further the OFR’s charge to monitor financial stability, the Office established a collection of data on these markets, shared this aggregated data with the public, and constructed a monitor to present these data.
Repurchase Agreements
The repo market is the largest short-term wholesale funding market in the United States. Between $2 trillion and $4 trillion of these short-term secured loans are traded every day. In repo markets, financial institutions such as banks, dealers, money market funds, and hedge funds lend and borrow on a short- term basis using a variety of financial instruments as collateral. Most repo transactions are conducted at overnight maturities. Technically, the borrower sells securities to the lender for a price, then very soon thereafter, usually the next day, buys them back at a predetermined higher price. The difference in price from one day to the next is, in substance, the interest paid on the loan of cash, collateralized by securities. Because of the secured and overnight nature of most of the repo market, these interest rates are often used as an overnight risk-free-rate against which other riskier interest rates can be calculated.
Centrally Cleared Repo Data Collection (Cleared Repo)
The OFR collects data on behalf of the FSOC and provides those data to the Council and its members. This year, to enhance the FSOC’s ability to identify and monitor potential risks to U.S. financial stability, the OFR established a data collection covering centrally cleared funding transactions in the U.S. repo market. The collection requires daily reporting to the OFR by central counterparty (CCP) clearing houses and marks the first time the OFR has gone directly to industry to collect financial market information on an ongoing basis. Despite the vulnerabilities of short-term funding markets, only a portion of the overall repo market was previously covered by regulatory data collections.
122 OFR ANNUAL REPORT TO CONGRESS 2020 Given the shared uses of collateral and links between the funding and asset markets, the risks of spillover and contagion can ripple through the markets. Anemic data collection could create blind spots that compromise financial stability. The cleared repo collection is an important step in closing this data gap, which can improve regulators’ capacity to monitor developments in various segments, identify emerging threats, and support the calculation of certain reference rates, specifically the new preferred benchmark, the Secured Overnight Financing Rate (SOFR).
U.S. Repo Markets Data Release
To improve transparency in repo markets, the OFR leveraged its cleared repo collection with previously available data to create a prototype high-frequency data product covering activity in repo markets. The U.S. Repo Markets Data Release contains daily data on rates and volumes in centrally cleared and tri- party repo markets. These data are broken out by tenor (the maturity of a short- term loan) and underlying collateral. This release is useful for understanding dynamics in repo markets, and provides more detail on overall activity in these markets than any other currently available source.
Short-term Funding Monitor (STFM)
To make the U.S. Repo Markets Data Release easily accessible to users, and to provide broader context, the OFR created the Short-term Funding Monitor to integrate data releases with existing data sets. Through the STFM’s market digests, users can access curated views with interpretive text provided by researchers at the OFR. These digests are split into different topics, such as rates, volumes, tenor, and the underlying collateral of a loan. Navigating these views, users can find digests of specific interest. The monitor also provides users deeper insights into how prices move in the repo market. Features include a flexible visualization tool with prepackaged views to allow monitoring of vulnerabilities; aggregated and masked data, free of sensitive disclosures and downloadable for analysis; and data made accessible via an application programming interface (API) for easy ingestion by other platforms. By making data describing short-term funding markets available in a variety of formats — from curated market digests, to individual series, to the ability to download and update data programmatically via the API — the OFR can increase the accessibility and extent of information the public has about short-term funding markets and their crucial role in the economy.
PART FOUR: THE OFR’S PERFORMANCE 123 FINANCIAL STRESS fund characteristics such the name and number of INDEX (FSI) as the types of assets held, the form used to collect investments by country, and the data, and the type of The FSI is a daily index counterparties involved. collection, such as financial that monitors stress in or supervisory. the financial system. It INTERAGENCY DATA is constructed from 33 INVENTORY BANK SYSTEMIC RISK financial market indicators, MONITOR (BSRM) such as yield spreads, The Foundations valuation measures, and for Evidence-Based In 2011, the Basel interest rates, and can be Policymaking Act of 2018 Committee on Banking decomposed by region or requires agency data to Supervision, a group of type of stress. The FSI’s be both accessible and bank supervisors from 28 timely indicators of financial capable of supporting jurisdictions, created a set stress at home and abroad statistical evidence, with the of 12 financial indicators to proved invaluable as the objective of informing the identify global systemically markets dropped in the making of effective policy. important banks (G-SIBs). first quarter of 2020, and The FSOC Interagency A G-SIB is a bank whose served as an effective tool Data Inventory is a catalog failure could pose a threat for navigating uncertainties of data collections from to the international financial throughout the year. FSOC members and other system. A bank identified government organizations. as a G-SIB must hold U.S. MONEY MARKET The inventory does not more risk-based capital to FUND (MMF) MONITOR contain data, but rather enhance its resilience and metadata — data about is subject to additional The MMF Monitor tracks data — on each collection. regulatory oversight. the investment portfolios These metadata are publicly of money market funds. In available but sometimes In 2016, the OFR created this year’s market of dips difficult to find. The its G-SIB Scores Interactive and spikes, the MMF gave Interagency Data Inventory Chart. As the needs and users the critical ability to is updated annually and requirements of the FSOC examine and track individual can be used to search and the global financial funds and market trends, for data collections and market expanded, the as well as connections analyze gaps and overlaps OFR replaced its G-SIB between money market in data collections. Each Scores Interactive Chart funds and securities issuers FSOC member organization with the Bank Systemic in the United States and determines which of its data Risk Monitor (BSRM) — a internationally. The MMF collections to include in the collection of key indicators converts data from the Inventory, which contains for monitoring systemic Securities and Exchange a brief description of each risks posed by the largest Commission’s Form N-MFP data collection, and basic banks. The BSRM allows into a user-friendly format information such as the users to easily assess a that allows users to chart collecting organization, bank’s systemic risk capital
124 OFR ANNUAL REPORT TO CONGRESS 2020 surcharge, total assets, institutions to reveal the Dictionary and look up leverage, and reliance potential loss that could “interest rate” and easily on short-term wholesale spill over to the rest of the view and understand how funding. Features include financial system if a given ISO 20022 defines this term. systemic importance scores bank were to default. for international and U.S. In 2020, the OFR worked banks, and the OFR’s FINANCIAL INSTRUMENT directly with SWIFT to Contagion Index, which REFERENCE DATABASE assess the content and structure of the data reflects the exposure of (FIRD) the financial system to the repository and establish activities and results of More than a decade the foundation for the Data these banks. ago, the Dodd-Frank Act Dictionary component established a mandate for of the FIRD. In the initial Components of the score OFR to prepare and publish phase, the Data Dictionary focus on the size of a bank a Financial Instrument covers five asset classes and its broader impact on Reference Database along with their associated the financial system based (FIRD) in a manner easily data elements (debt, on: accessible to the public. equity, warrant, option, and The OFR will deliver the first future). The OFR is targeting • the extent of the bank’s phase of this mandate by completion of front-end network of obligations year-end 2020. development by the end of within the financial 2020. system; During the FIRD’s initial Future phases will include • the unique proposition of phase, the OFR is an expansion of OFR’s its offerings and services developing a foundational Data Dictionary to add not easily replaced by Data Dictionary, leveraging asset classes and new others; the ISO 20022 financial message standard that is data elements, such as the • the complexity of the available on a free and open ISO 20022 Critical Data bank’s operations as it basis. This international Elements for derivatives pertains to the various data standard covers the instruments being finalized asset classes in which it’s bulk of financial instruments by the Financial Stability involved; and supports the creation Board’s Group on UTI and UPI Governance and • and the coverage of financial messages for communicating buy and sell targeted for integration it provides across in ISO 20022 in 2021. international borders. transactions, and interest and dividend payments. This expansion aligns with SWIFT’s call for global use Users have access to data ISO 20022 also contains of ISO 20022 for all financial tabs, customizable charts, the granular data elements data reporting and avoids and the OFR’s Contagion that form the reference data “breaking the chain” to Index, which considers size, for financial instruments. reach full migration. leverage, and relationships For example, a user will be with other financial able to go into the Data
PART FOUR: THE OFR’S PERFORMANCE 125 COLLABORATION publications are consistent with the OFR’s mission. This FINANCIAL RESEARCH SUPPORT FOR THE year, at the request of the FSOC, the OFR conducted ADVISORY COMMITTEE FINANCIAL STABILITY a literature review on the MEETINGS OVERSIGHT COUNCIL Current Expected Credit AND ITS MEMBERS Loss (CECL) standard. Feb. 27, 2020 The OFR supports the FINANCIAL RESEARCH FSOC and its members ADVISORY COMMITTEE Department of the Treasury, by providing research and (FRAC) Washington. The 15th analysis to help identify meeting of the FRAC, held threats to financial stability, The FRAC provides industry, in the Cash Room at the fulfilling FSOC requests academic, and government main Treasury building, for research and analysis, expertise to the OFR and included discussions of and working with FSOC informs OFR’s work on capital adequacy and members on research and research and data issues. financial transparency. data projects. As one of the Its members are experts world’s foremost experts in in business, economics, July 16, 2020 setting data standards, the finance, data science, OFR collects, maintains, risk management, and Virtual meeting. The 16th and shares supervisory information technology. meeting of the FRAC and commercial datasets The committee meets twice included discussions of with the FSOC. Our Office each year and is governed passive investing, and basis also leads the FSOC Data according to the Federal trades and Treasury market Committee and works with Advisory Committee Act. illiquidity. the FSOC Systemic Risk The agenda and minutes Committee to address data are publicly available. In STANDARDS BODIES gaps, provide a forum for February 2020, the FRAC AND PUBLIC FORUMS information sharing among shared its findings on the FSOC’s Chief Data where the most important Officers and representatives, Participating and taking capital adequacy issues leadership roles in the coordinate action on data- are in today’s financial related topics, and oversee initiatives of U.S. and system and where increased international standards the annual update to the transparency can further Interagency Data Inventory. bodies allows the OFR financial stability. In July to collaborate with The OFR’s Director serves 2020, the Committee as a nonvoting member of domestic and international discussed the shift to counterparts on matters the FSOC, and the OFR passive (index) investment and the FSOC Secretariat of common interest (see strategies and recent Figure 81). Foremost work together to ensure lessons for financial stability. proposed research and amongst the OFR’s data topics, projects, and domestic counterparts are FSOC members.
126 OFR ANNUAL REPORT TO CONGRESS 2020 Figure 81. Standards Bodies in Which the OFR Participated in 2020
1 Legal Entity Identifier Regulatory Oversight Committee 1.1 Executive Committee 1.2 Plenary 1.3 Plenary – Joint ROC-GUUG Small Group 1.4 Committee on Derivative Identifiers and Data Elements 1.5 Committee on Evaluation and Standards – Data Quality Working Group 1.6 Committee on Evaluation and Standards – Level 2 Data Working Group
2 Financial Stability Board – Working Groups on Governance 2.1 UTI, UPI, and CDE Governance Group 2.2 CDE Message Group 2.3 UPI Technical Analysis Group – Substream 3
3 International Organization for Standardization, TC 68 – Subcommittee 8 3.1 WG 1 – ISO 10962, Classification of Financial Instruments (CFI) Code 3.2 WG 4 – Revision of ISO 17442, Legal Entity Identifier (LEI) 3.3 WG 5 – ISO 23897, Unique Transaction Identifier (UTI) 3.4 WG 7 – ISO 24366, Natural Persons Identifier (NPI) 3.5 WG 8 – ISO Unique Product Identifier (UPI)
4 International Organization for Standardization, TC 68 – Subcommittee 9 4.1 WG 1 – ISO 20022 Semantic Models 4.2 SG 1 – Review of ISO 20022 Standards Release Comments
5 International Organization for Standardization, TC 68 – Advisory Groups 5.1 AG3 – Standards Best Practices 5.2 TAG 1 – Fintech Technical Advisory Group
6 Accredited Standards Committee X9, Inc. 6.1 Board of Directors and Executive Committee 6.2 X9D Securities Subcommittee – Chair 6.3 X9D Securities Subcommittee – ISO 17442 LEI Mirror Group 6.4 X9D Securities Subcommittee – ISO 24366 NPI Mirror Group 6.5 X9D Securities Subcommittee – ISO 6166 ISIN Mirror Group 6.6 X9D Securities Subcommittee – X9D1 ANSI X9.145 FIGI 6.7 X9D Securities Subcommittee – X9D2 ANSI X9.6 CUSIP
Source: Office of Financial Research
PART FOUR: THE OFR’S PERFORMANCE 127 International counterparts to future systemic shocks. cost savings on hardware include financial regulatory Topics included the and software licensing. The authorities, finance effects of macroprudential OFR will continue migrating ministries, and central and monetary policy on to cloud services and banks. Participating and financial stability, regulatory reengineering the OFR’s taking leadership roles challenges of technological telecommunication network. in the initiatives of these advances on financial bodies also provides markets and financial REMOTE CAPABILITIES opportunities to collaborate institutions, and systemic with representatives from risks and risk mitigants In the first quarter of 2020, the private sector. In associated with nonbank a few weeks before moving addition to participating in financial institutions. to 100 percent telework due the initiatives of standards Participants from industry, to the COVID-19 pandemic, bodies, the OFR engages regulatory agencies, the OFR replaced obsolete in collaborative, open and academia shared laptops and deployed a discussions in public their insights in keynote new remote office with forums about standards addresses and panel collaboration capability. matters. In June 2020, OFR discussions. The timing of these efforts, participated in a panel which followed the new strategic plan, proved discussion hosted by the INFORMATION ISITC, a financial services invaluable after the full- industry group focused on TECHNOLOGY (IT) time telework directive, trade-processing standards, giving 100 percent of the on the topic of standards for CLOUD RESOURCES OFR workforce remote industry sector classification. AND INCREASED access and collaboration The panelists included capabilities. Employee CAPABILITIES representatives from the engagement and public and private sectors. As part of a multiyear effort, productivity proved to be the Technology Center exceptional. CONFERENCES focused on migrating more COSPONSORED IT systems and workloads to DATA COLLECTION AND cloud computing services. MANAGEMENT On Nov. 21-22, 2019, the Significant advances OFR joined the Federal included deployment of The Technology Center led Reserve Bank of Cleveland security, auditing, and the development of the to host their annual financial authorization control expanded Bank Systemic stability conference in Ohio. systems. Such systems Risk Monitor. The center The focus was on identifying let the OFR manage and also realigned functions risks to financial stability track which data individual in the Analytic and Data and developing appropriate users see. The OFR also Stewardship roles to enable, policy tools to enhance moved several terabytes develop, and support the the resilience of financial of archived data to the daily intake and production markets and institutions cloud, creating significant of the Short-term Funding
128 OFR ANNUAL REPORT TO CONGRESS 2020 Monitor, ensuring it met system to ensure that it The Research and Analysis the target publication time is configured properly to Center conducts applied every day, after completion meet the security mandate. and essential long-term of the data intake, load, A FISMA-compliant SA&A research and analysis to validity, and quality checks. is required for a system, support the stability of the And, in close cooperation application, or environment U.S. financial system. The with the Data Standards to get an Authority to Center produces financial Group, the Technology Operate. In FY 2020, the stability monitors, research Center led the development OFR completed its triennial and briefings for the FSOC efforts of the first release Security Assessment and and other stakeholders, of the Financial Instrument Authorization. and evaluations of financial Reference Database. stability policies to promote OFR ORGANIZATION best practices in financial DATA AND risk management. The Research and Analysis INFORMATION SECURITY The OFR’s directive to Center has two sections, support the FSOC and Data and Information Financial Institutions and its members is achieved Security continues to be Financial Markets, requiring through leading research, a primary area of focus. advanced analytical analysis, and risk- Federal agencies are capabilities and intellectual monitoring tools, as well mandated by the Federal resources to address a as the management of Information Security wide range of questions the interagency data Management Act (FISMA) related to financial stability, inventory, development of to understand the security as well as deep subject financial data standards, risks posed to their matter expertise regarding and yearly assessments on information technology financial markets, financial significant developments systems, applications, institutions, and the in the financial system and and environment, and are regulations affecting them. potential threats to financial required to take appropriate stability. actions to mitigate these The Data Center leads and supports global efforts risks. To help agencies In 2020, the OFR Director, to develop and improve evaluate these risks, Dino Falaschetti, completed data standards that further the National Institute of his first year of a six-year efficiencies in reporting and Standards and Technology term. In addition to leading analyzing financial data. The (NIST) developed a the OFR, working closely Data Center also develops Security Assessment and with the OFR’s senior data products and promotes Authorization (SA&A) managers, he engages appropriate data-sharing methodology for federal directly with a broad array to meet stakeholder needs. information systems, NIST of stakeholders, including The Data Center has two SP 800-53. The SA&A is a the FSOC and its members, sections: Data Strategy formal methodology for Congress, industry, and Standards, which testing and evaluating the international entities, and works to develop, identify, security controls of the the FRAC.
PART FOUR: THE OFR’S PERFORMANCE 129 and promote standards for OFR operational totaled 107 as of Sept. 30, for financial data and policies, procedures, and 2020. data collection; and Data controls. The division works Products, which provides closely with the Treasury The OFR Director is data and related products to Department’s Office of committed to building stakeholders. the Assistant Secretary for sound working relationships Management. with employees and The Technology Center supporting team building oversees OFR information The Office of the Chief with an emphasis on public technology systems and Counsel, which reports service. As a continued system security, including directly to the Treasury effort to improve the OFR an IT platform to support Department’s Office culture and employee analysis with large-scale of General Counsel, engagement, the Director data sets. The Technology provides legal guidance on hosted small-group OFR Center also acquires research and analysis, data Employee Lunches in the commercial, nonpublic, and acquisition and use, policy first half of FY 2020 to proprietary data through initiatives, procurements, identify what employees procurements, provider and agreements with other need to succeed and agreements, and the OFR’s organizations. The Office to solicit employee own collection activities. The of the Chief Counsel also recommendations to Technology Center has five coordinates the OFR’s further inform the OFR’s sections requiring expert responses to oversight human capital strategy. The capabilities in many IT fields: bodies, such as auditors and Director’s initial priorities Technology Management Congress. included a focus on security and Procurement; in the workplace and Information Security; GROWTH MANAGEMENT management transparency Analytic Systems Support; in conducting business. Enterprise Systems Support; The OFR continues to The OFR contracted with and Data Operations. build through recruitment the Federal Mediation efforts for key positions and Conciliation Service The Operations Division and skills. Positions filled in the second quarter to provides expertise, this year included the serve in an ombudsperson implementation, policy, Principal Deputy Director capacity. This initiative and oversight for a variety of Research, Analysis and provides an independent, of organizational needs: Data; Deputy Director for third-party resource for strategy and performance, Technology; Associate OFR employees to address budgeting, publications, Director of Data Products; any management issues. travel, administrative and several Researcher The Director’s priorities support, human resources, and IT positions. Senior also included developing procurement, and facilities. management continuously the OFR Workforce Plan The Operations Division has reviews the organization 2020-2024, which identifies two sections, Operational to ensure critical needs are opportunities to address Support and Management satisfied. The Office staff workforce gaps regarding Support, with responsibility
130 OFR ANNUAL REPORT TO CONGRESS 2020 employee development, Viewpoint Survey results ongoing basis and progress recruitment, and retention. and developing an Office- is shared with all OFR In addition, the Director’s wide action plan to improve employees. priorities included employee engagement and managers reviewing organizational culture. The BUDGET the Federal Employee action plan is updated on an The OFR obligated $62.69 million in FY 2020, 42 Figure 82. OFR Funds Obligated in Fiscal Years percent for labor and 58 2015-20 ($ thousands) percent for other expenses (see Figure 82). A large 2015 2016 2017 2018 2019 2020 portion of the nonlabor figure is due to significant Compensation 29,036 32,485 37,379 31,991 18,095 19,205 OFR expenses, particularly Benefits 9,507 11,322 13,054 10,932 6,860 7,100 in the Technology Center ($23.4 million), which Benefits support the OFR’s unique to Former 292 mandates. Employees By statute, the OFR Labor Total 38,543 43,807 50,433 42,923 25,247 26,305 is not funded by annual Congressional Travel 453 556 447 147 156 75 appropriations, but Transportation 2 rather by semiannual assessments from bank Communication 3,811 62 179 131 68 116 holding companies with and Utilities total consolidated assets of Printing and 31 26 22 8 7 7 $250 billion or more each, Reproduction a threshold that identifies Other Services 25,033 35,794 31,823 26,353 26,648 25,815 them as global systemically important banks, and Supplies and 8,060 8,312 6,508 5,649 6,118 9,837 nonbank financial Materials companies supervised by Equipment 8,785 5,997 3,459 679 309 535 the Board of Governors of the Federal Reserve System. Grants 320 The OFR pays the Treasury Nonlabor Total 46,173 51,067 42,438 32,967 33,308 36,385 Department nearly $8 million per year to TOTAL 84,716 94,874 92,871 75,890 58,555 62,690 support the OFR’s human resources, budget, travel, Note: Other services include rent and administrative support for human and acquisitions activities. resources, conferences and events, facilities, and procurement. In addition, the OFR pays
Source: Office of Financial Research Treasury more than $5
PART FOUR: THE OFR’S PERFORMANCE 131 million annually for IT circuits, payroll services, and agency-wide systems for training, performance management, and human resources management. The OFR Director must consult with the FSOC Chairperson in establishing the OFR budget and workforce.
132 OFR ANNUAL REPORT TO CONGRESS 2020 GLOSSARY ENDNOTES BIBLIOGRAPHY
GLOSSARY
Accommodation Expansionary monetary policy Attestation In an attestation engagement, a in which a central bank seeks to lower borrowing certified public accountant is engaged to issue costs for businesses and households to make or does issue an examination, review, or agreed- credit more easily available. upon procedures report on subject matter, Activities-based approach An approach or an assertion about the subject matter that to examining risks to financial stability by is the responsibility of another party. Under examining a diverse range of financial products, the Sarbanes-Oxley Act of 2002, independent activities, and practices. auditors attest to and report on public company managers’ assessments of internal controls over Adverse selection When sellers have more their companies’ financial reporting. information than buyers have, or vice versa, about some aspect of product quality. Adverse Auditor opinion Statements auditors include selection can impose higher risk on the less- in their reports on company finances. Auditors informed party. issue adverse opinions when they have concerns that the statements have not been Agency mortgage-backed securities Securities prepared along accepted principles or that made up of mortgages purchased by housing the data supporting the statements have been finance agencies Fannie Mae, Freddie Mac, misrepresented. They issue clean opinions and Farmer Mac, or guaranteed by housing when they find no significant exceptions to finance agency Ginnie Mae. The agencies set accepted accounting practices and disclosure underwriting requirements for the loans they will requirements. Auditors issue opinions with an purchase or guarantee. explanation for various reasons, including when Alternative Reference Rates Committee they want to call out something that might be (ARRC) A committee that includes banks, material. asset managers, insurers, and industry trade Authorized participant A liquidity provider organizations as well as federal and state to an exchange-traded fund. When there is a financial regulators as ex-officio members; shortage of exchange-traded fund shares in the committee chose the Secured Overnight the market, the authorized participant creates Financing Rate (SOFR) as its recommended more shares. When there is an excess supply of alternative to U.S. dollar LIBOR. shares, the participant redeems shares to reduce Aruoba-Diebold-Scotti Business Conditions the number of shares on the market. Index Index designed by Federal Reserve Bank Bagehot’s Dictum Theory of Walter Bagehot, a of Philadelphia researchers to track real business 19th century writer and banker, who proposed conditions at high frequency by using a mix of central banks should lend freely and often economic and financial indicators. against good collateral and at high interest rates Asymmetric information When one party to a to quell a financial panic. transaction has greater material knowledge than Bail-in The approach to a failed or near-failed the other party. entity in which its creditors write down their
GLOSSARY 135 claims to make the entity solvent, as opposed to Brexit An abbreviation for “British exit,” the the provision of government support. departure of the United Kingdom from the Bank for International Settlements (BIS) An European Union. international financial organization that serves Brokered deposit A government-insured central banks in their pursuit of monetary and deposit that a bank obtains through a brokerage. financial stability, helps to foster international These funds may leave the bank quickly when a cooperation, and acts as a bank for central competitor offers a higher rate. banks. Business development company (BDC) Type of Bank holding company (BHC) Any company closed-end fund that primarily invests in small or that has direct or indirect control of one or developing companies. BDCs are often publicly more banks and is regulated and supervised by traded companies and are regulated by the the Federal Reserve under the Bank Holding Securities and Exchange Commission. Company Act of 1956. BHCs may also own The Three C’s Connectedness, correlation, and nonbanking subsidiaries such as broker-dealers contagion – three key sources of systemic risk. and asset managers. Call report A quarterly report of a bank’s Basel Committee on Banking Supervision financial condition and income that all federally (BCBS) An international forum for bank insured U.S. depository institutions must file. supervisors that aims to improve banking Capital The difference between a firm’s assets supervision worldwide. The BCBS develops and its liabilities, capital represents the net worth guidelines and supervisory standards, such of the firm or the firm’s book equity value to as standards on capital adequacy, the core investors. principles for effective banking supervision, and recommendations for cross-border banking Capital conservation buffer Additional capital supervision. banks are required to hold outside periods of financial stress, meant to be drawn down during Basel III A comprehensive set of global times of stress. This buffer is intended to prevent regulatory standards to strengthen the breaches of minimum required capital ratios. regulation, supervision, and risk management of the banking sector. The measures include bank Capital requirement The amount of capital and banking system regulation to strengthen a regulator requires a bank to have to act as firms’ capital, liquidity, risk management, a cushion to absorb unanticipated losses and and public disclosures to reduce the banking declines in asset values that could otherwise system’s vulnerability to shocks. cause a bank to fail. Blockchain Common name for cryptographic CARES Act The Coronavirus Aid, Relief, distributed ledger technology used to record and Economic Security Act of 2020, stimulus online transactions. Blockchains are the basis of legislation to buffer the consequences of the cryptocurrencies. COVID-19 pandemic and related economic shutdowns. Bond duration The measure of a bond’s market price sensitivity to interest rate changes, Central clearing A settlement system in which measured in years. Price risk rises as duration securities or derivatives of a specific type are increases. cleared by one entity that guarantees the trades, such as a clearinghouse or central counterparty. Central clearing is an alternative to bilateral or
136 OFR ANNUAL REPORT TO CONGRESS 2020 over-the-counter trading (see over-the-counter Collateralized loan obligation (CLO) Securities derivatives). that hold pools of corporate loans and are sold Central counterparty (CCP) An entity that to investors in tranches with varying levels of risk. interposes itself between counterparties to Commercial mortgage-backed securities contracts traded in one or more financial (CMBS) Securities collateralized by commercial markets. A CCP becomes the buyer to every mortgages. seller and the seller to every buyer to help Commercial paper Short-term (maturity of up to ensure the performance of open contracts. 270 days), unsecured corporate debt. Charge-off rate (for banks) Realized loan losses Commercial Paper Funding Facility (CPFF) A as a percent of total loans. The net charge-off Federal Reserve facility that finances commercial rate subtracts recoveries on written-down debt paper issuance. from gross charge-offs. Committee on Capital Markets Regulation An Circuit breakers A market regulatory mechanism independent research organization created in to stop trading in the public markets when 2006 and focused on policy reforms to develop prices of certain instruments drop more than a efficient and stable capital markets. predefined amount. Committee on Payments and Market Clearing A system that transfers ownership Infrastructures (CPMI) A standing committee of securities when they are traded and makes of the Bank for International Settlements. related payments. Representatives are senior officials of member Clearing bank A commercial bank that facilitates central banks. The CPMI promotes safety and payment and settlement of financial transactions, efficiency of payment, clearing, settlement, such as check clearing or matching trades and related activities, and it serves as a global between the sellers and buyers of securities and standard-setting body in this area. other financial instruments or contracts. Comprehensive Capital Analysis and Review Clearing member A member of, or a direct (CCAR) The Federal Reserve’s annual exercise participant in, a central counterparty that is to ensure that the largest U.S. bank holding entitled to enter into a transaction with the CCP. companies have robust, forward-looking capital Coasean lens A perspective of contemporary planning processes that account for their unique British economist and Nobel laureate Ronald risks and sufficient capital for times of financial Coase that deemphasized oversight and and economic stress. The CCAR exercise also regulation in favor of rewarding accessible evaluates the banks’ individual plans to make information in competitive markets to reveal capital distributions such as dividend payments systemic risk and create opportunity. or stock repurchases. Collateral Any asset pledged by a borrower to Concentration risk Any single exposure or guarantee payment of a debt. group of exposures to the same risk with the potential to produce losses large enough Collateralized debt obligation (CDO) Securities to threaten a financial institution’s ability to that hold a pool of debt and are sold to investors maintain its core operations. in tranches with varying levels of risk. Leading up to the 2007-09 financial crisis, many CDOs Conditional Value-at-Risk (CoVaR) CoVaR consisted of repooled residential mortgage- indicates an institution’s contribution to systemic backed securities (RMBS). risk, calculated as the difference between value-
GLOSSARY 137 at-risk (VaR) of the financial system when the firm Credit gap A metric in which the ratio of debt- is under distress and the VaR of the system when to-gross domestic product (GDP) is measured the firm is in its regular, median state. against its statistically estimated long-run trend. Contingent convertible (CoCo) bonds Credit rating agency Private company that Hybrid capital securities structured as debt assesses the creditworthiness of a borrower or a but that absorb losses in accordance with their financial instrument. contractual terms when the capital of the issuing Credit risk The risk that a borrower may default bank falls below a certain level. Due to their loss- on its obligations. absorbing capacity, CoCos can be used to satisfy Credit Risk Transfer (CRT) bonds CRT bonds regulatory capital requirements. allow Fannie Mae, Freddie Mac, and sometimes Council of Economic Advisers (CEA) An agency reinsurance companies, to transfer mortgage within the Executive Office that advises the credit risk to private investors. President of the United States on economic Cryptocurrency Digital financial assets policy. (cryptoassets) based on blockchain Countercyclical capital buffer A component of cryptographic technology. Bitcoin is the most Basel III requiring banks to build capital buffers widely used cryptocurrency. during favorable economic periods. The buffers Current expected credit loss (CECL) can be used to absorb losses in unfavorable Accounting framework for creating reserves periods. for credit losses. Requires firms applying U.S. Counterparty risk The risk that the party on the Generally Accepted Accounting Principles to other side of a contract, trade, or investment will hold credit loss allowances equal to expected default. credit losses for the lifetime of certain assets. Covenant-lite loans Loans that do not include Cybersecurity risk The vulnerability of or include weak versions of typical covenants to information technology and computer systems protect lenders, such as requiring the borrower to unauthorized access. Innovations such as to deliver annual reports or restricting loan-to- quantum computing may increase the ability of value ratios. nefarious players to access encrypted data. COVID-19 A highly contagious respiratory Cybersecurity Assessment Tool A tool illness caused by a coronavirus and declared designed to complement the National Institute a pandemic in 2020 by the World Health of Standards and Technology’s Cybersecurity Organization. Framework. The Federal Financial Institutions Credit default swap (CDS) A bilateral contract Examination Council developed the tool to protecting the buyer against the risk of default help financial institutions identify and address by a borrower. The buyer of CDS protection cybersecurity risks and determine their level of makes periodic payments to the seller and, in cybersecurity maturity in addressing those risks. return, receives a payoff if the borrower defaults. Dash to cash A simultaneous move by The protection buyer does not need to own the participants in money and capital markets to loan covered by the CDS. raise cash by selling assets, including Treasuries, Credit default swap spread The premium paid and to withdraw from investment funds, creating by the buyer of credit default swap protection to volatility and price drops. the seller.
138 OFR ANNUAL REPORT TO CONGRESS 2020 Debt securitization The aggregating of debt Disruption A sudden decline in market prices instruments into a pool backing the creation of due to a shock that upends the expected one or more securities. behavior of the financial system. Default waterfall The financial safeguards Distress Insurance Premium (DIP) A systemic available to a central counterparty to cover risk indicator that measures the hypothetical losses arising from the default of one or more contribution a financial institution would make clearing members. to an insurance premium that would protect the Defensive draws A strategy by borrowers to whole financial system from distress. draw down their credit lines to raise cash in Distress ratio The portion of high-yield debt at advance of need. face value trading at distressed levels. Defined-benefit pension plan A plan where Distributed ledger technology See members’ pension benefits are determined blockchain. by formula, usually tied to years of service Dodd-Frank Act Short name for the Dodd- and earnings during service, regardless of Frank Wall Street Reform and Consumer the assets in the plan. This contrasts with a Protection Act of 2010. The objective of the Act defined-contribution plan such as a 401-K, is to promote financial stability. where benefits are determined by returns on a Dodd-Frank Act Stress Test (DFAST) Annual portfolio of investments. large bank stress tests required by the Dodd- Depository institution A financial institution, Frank Act. A 2018 law change means banks such as a bank or credit union, that has with assets less than $100 billion no longer go liabilities in the form of deposits. through DFAST. Depository Trust & Clearing Corporation Duration risk The risk associated with the A company that processes and clears trades as sensitivity of the prices of bonds and other the central clearing house for the U.S. capital fixed-income securities to changes in the level markets and repository for the derivatives of interest rates. market. Economic Growth, Regulatory Relief and Derivative A financial contract whose value is Consumer Protection Act of 2018 Law that derived from the performance of underlying adjusted some provisions of the Dodd-Frank assets or market factors such as interest rates, Act, as well as instituting tax law changes. currency exchange rates, or commodity, credit, Emerging markets Developing countries where and equity prices. Derivatives transactions investments are often associated with both include structured debt obligations, swaps, higher yields and higher risks. futures, options, caps, floors, collars, and forwards. European Central Bank’s (ECB) Public Sector Purchase Program (PSPP) A process by Derivatives counterparties Parties to a which the ECB (or “Eurosystem”) buys assets, derivatives transaction, either trading with including sovereign bonds, to help maintain each other bilaterally (over the counter) or via a stability in various countries. central counterparty. The European Securities and Markets Discount window The Federal Reserve’s Authority The European Union’s securities traditional facility for making collateralized market regulator. loans to depository institutions.
GLOSSARY 139 Eurozone or euro area A group of 19 European Federal Open Market Committee (FOMC) Union countries that have adopted the euro as Twelve-member body within the Federal Reserve their currency. System that sets national monetary policy, Exchange-traded fund (ETF) An investment including setting the target range for the federal fund whose shares are traded on an exchange. funds rate. Because ETFs are exchange-traded products, Federal Reserve’s emergency section 13(3) A their shares are continuously priced, unlike section of the Federal Reserve Act that allows mutual funds, which offer only end-of-day emergency lending from the Federal Reserve to pricing. ETFs are often designed to track an financial institutions and others in “unusual and index or a portfolio of assets. exigent circumstances” with the approval of the Fallen angel Bond downgraded from investment Secretary of the Treasury. grade to non-investment grade. Feedback loop (negative) The downward price Federal Deposit Insurance Corporation pressure created when parties meet margin Improvement Act of 1991 (FDICIA) A law that payment obligations on some securities by requires federal banking agencies to take action liquidating positions in other related securities. when an insured depository institution’s capital Financial contagion When financial or economic declines below a predefined level, and in the shocks initially affect only a few financial market case of bank failures, enact a resolution that is participants and then spread to other parts the least burdensome to taxpayers. of the financial system and countries. The risk Federal Financial Institutions Examination of contagion increases with the number and Council (FFIEC) An interagency body that complexity of interconnections. prescribes uniform principles, standards, Financial crisis A significant, sustained drop and report forms for the federal examination in asset prices, income streams, credit, and of financial institutions. The FFIEC makes liquidity, resulting from an event that shocks the recommendations to promote uniformity in financial system, usually triggering government banking supervision. interventions and bailouts. Federal funds (fed funds) Overnight interbank Financial market utility (FMU) As defined by borrowing of reserves at the Federal Reserve. the Dodd-Frank Act, “any person that manages Federal funds rate Interest rate at which or operates a multilateral system for the purpose depository institutions lend fed funds to each of transferring, clearing, or settling payments, other. securities, or other financial transactions among financial institutions or between financial Federal Home Loan Banks (FHLBs) Eleven institutions and the person.” U.S. government-sponsored banks that provide funding for member financial institutions, mostly Financial stability The condition in which through advances secured by mortgages. the financial system can provide its basic functions, even under stress. Those basic Federal Housing Finance Agency (FHFA) functions are (1) credit allocation and leverage, Agency responsible for supervision, regulation, (2) maturity transformation, (3) risk transfer, (4) and housing mission oversight of Fannie Mae, price discovery, (5) liquidity provision, and (6) Freddie Mac and the Federal Home Loan Bank facilitation of payments. System; it is also the conservator of Fannie Mae and Freddie Mac.
140 OFR ANNUAL REPORT TO CONGRESS 2020 Financial Stability Board (FSB) An international the Securities and Exchange Commission, which coordinating body that monitors financial system makes the information publicly available. SEC developments on behalf of the Group of 20 (G- Rule 30b1-7 established the technical and legal 20) nations. The FSB was established in 2009 and details of N-MFP filings. is the successor to the Financial Stability Forum. Form PF A periodic report of portfolio holdings, Financial Stability Oversight Council (FSOC) leverage, and risk management submitted by A government body created by the Dodd- hedge funds, private equity funds, and related Frank Act, consisting of the heads of all federal entities. The report is filed with the Securities financial regulatory agencies and others, with a and Exchange Commission and the Commodity statutory mandate to identify risks and respond Futures Trading Commission, which keep the to emerging threats to financial stability. Chaired information confidential. The Dodd-Frank Act by the Secretary of the U.S. Treasury, the Council mandated the reporting to help the FSOC consists of 10 voting members and five non- monitor financial stability risks. voting members, including the OFR Director. Funding gap The difference between rate- Fintech Financial technology, usually referring to sensitive assets and liabilities. One measure of firms that operate on technology-based business the funding gap ratio is liabilities due in one year models. minus liquid assets, divided by total assets. Fire sale The disorderly liquidation of assets Funding liquidity The availability of credit to to meet margin requirements or other urgent finance the purchase of financial assets. cash needs, which can drive prices below their Generally Accepted Accounting Principles fundamental value. The quantities sold are large (GAAP) Accounting rules published in the relative to the typical volume of transactions. United States by the Financial Accounting Fiscal policy Use of government spending and Standards Board. taxes to influence the economy. Global systemically important banks Forbearance (debt forbearance) An (G-SIBs) Banks annually identified by the Basel agreement between borrowers and lenders, or Committee on Banking Supervision as having a government mandate, to suspend payments the potential to disrupt international financial temporarily without being considered in default. markets. The designations are based on banks’ Under the CARES Act, mortgage servicers were size, interconnectedness, complexity, dominance required to grant payment forbearance, for in certain businesses, and global scope. 180 days, to borrowers experiencing financial Global systemically important insurers (G-SIIs) hardship and who had mortgages backed by the Insurance companies annually identified by the government. Financial Stability Board for having the potential Foreign and International Monetary to disrupt international financial markets because Authorities (FIMA) Repo Facility Allows foreign of their size, market position, and global central banks and international monetary interconnectedness. authorities with which the Federal Reserve Government-sponsored enterprise (GSE) A doesn’t have swap agreements to borrow dollars financial service entity created by the federal against Treasury securities. government and perceived as being implicitly Form N-MFP A monthly disclosure of portfolio guaranteed by the government. The GSEs holdings submitted by money market funds to include Fannie Mae, Freddie Mac, Sallie Mae,
GLOSSARY 141 Farmer Mac, the Federal Home Loan Banks, the pay a higher interest rate than investment- Farm Credit System, and the National Veteran grade securities because of the perceived credit Business Development Corporation. risk; also known as non-investment grade or Gross notional exposure (GNE) A measure of speculative. total portfolio leverage, for example in a hedge Incurred-loss accounting framework An fund. GNE is calculated as the summed absolute accounting framework for firms in which loan values of long and short notional positions, loss allowances are equal to the losses related including both securities and derivatives. to recognized credit impairments. Compare Hacktivist Someone who infiltrates computer CECL. systems and networks to promote a social or Initial margin A percentage of the total market political agenda. value of securities an investor must deposit Haircut The discount at which an asset is valued up front to purchase securities with borrowed when pledged as collateral. For example, a $1 funds. million bond with a 5 percent haircut would Intraday credit An allowance by banks for collateralize a $950,000 loan. customers to borrow money or overdraw Hedge fund A pooled investment vehicle accounts during a single day, at no charge, as available to accredited investors such as wealthy long as it is repaid by the close of business that individuals, banks, insurance companies, and same day. trusts. Hedge funds can charge a performance Institutional loans When referring to the fee on unrealized gains, borrow more than leveraged loan market, term loans originated half of their net asset value, short sell assets by bank syndicates and sold to institutional they expect to fall in value, and trade complex investors. derivative instruments that cannot be traded by Interest coverage ratio A calculation of mutual funds (see qualified hedge fund). earnings divided by interest expense. Interest Hedging An investment strategy to offset the expenses that are equal to or greater than risk of a potential change in the value of assets, earnings before interest and taxes (EBIT) or liabilities, or services. An example of hedging is earnings before interest, taxes, depreciation, buying an offsetting futures position in a stock, and amortization (EBITDA) are unsustainable. interest rate, or foreign currency. Interest rate swap A swap in which two parties High-frequency trading The use of exchange interest rate cash flows, typically computerized securities trading platforms to between a fixed rate and a floating rate (see make large numbers of transactions at high swap). speeds. Intermediation Any financial service in which High-quality liquid assets (HQLA) Assets such a third party or intermediary matches lenders as central bank reserves and government bonds and investors with entrepreneurs and other that can be quickly and easily converted to borrowers in need of capital. Often, investors cash even during a stress period. U.S. banking and borrowers do not have precisely matching regulators require large banks to hold HQLA to needs and the intermediary’s capital is put at comply with the Liquidity Coverage Ratio. risk to transform the credit risk and maturity of High-yield debt Bonds and other financial the liabilities to meet the needs of investors. instruments rated below investment grade that
142 OFR ANNUAL REPORT TO CONGRESS 2020 International Monetary Fund (IMF) An assets to policyholder surplus. For hedge funds, international organization that provides credit the leverage ratio is gross asset value divided to developing nations and those in economic by net asset value. distress, typically conditional on economic and Leveraged loan Broadly, leveraged loans are financial reforms. loans to companies with non-investment grade International Organization of Securities (below BBB) ratings. Often, a leveraged loan Commissions (IOSCO) IOSCO is the is a loan for which the obligor’s post-financing international body for securities regulators, and leverage, as measured by debt-to-assets, debt- is the recognized standard setting organization to-equity, cash flow-to-total debt, or other for the securities industry. IOSCO works closely such standards unique to particular industries, with the G-20 forum of nations and the Financial significantly exceeds industry norms. Leveraged Stability Board on global financial regulatory borrowers typically have a diminished ability reforms. to adjust to unexpected events and changes Intervention Action taken by the government in business conditions because of their higher to regulate or provide financing to unstable ratio of total liabilities to capital. financial markets or institutions. LIBOR Formerly known as the London Interbank Inverted yield curve When yields on long- Offered Rates, estimates of the interest rates term bonds are lower than those on short-term at which banks can borrow from other banks bonds, the yield curve is said to be inverted. in London wholesale markets, as measured An inverted yield curve is seen as a sign of a by a daily survey. LIBOR is still a widely used possible recession. reference rate system, but is being phased out under regulatory direction. Investment-grade debt Securities that credit rating agencies determine carry less credit risk. Liquidity A market is liquid when buyers and Non-investment grade securities, also called sellers can easily trade financial instruments in speculative-grade or high-yield debt, have customary volumes without a material impact lower ratings and a greater risk of default. on price. Legal Entity Identifier (LEI) A unique 20-digit Liquidity Coverage Ratio A Basel III standard alphanumeric code to identify each legal entity that requires large banks maintain enough within a company that participates in global high-quality liquid assets to meet anticipated financial markets. liquidity needs for a 30-day stress period. Leverage Leverage is created when an entity Liquidity risk The risk that a firm will not be enters into borrowings, derivatives, or other able to meet its current and future cash flow transactions resulting in investment exposures and collateral needs even if it has positive net that exceed equity capital. worth. Leverage ratios (banks, insurance companies, Liquidity transformation Funding illiquid hedge funds) For banks, the leverage ratio assets with liquid and demandable liabilities. is the Tier 1 (highest quality) capital of a Living wills Resolution plans required of bank divided by its total assets plus its total U.S. banks with $50 billion or more in total exposures to derivatives, securities financing consolidated assets and nonbank financial transactions, and off-balance-sheet exposures. companies designated by the FSOC for For insurance companies, the leverage ratio is supervision by the Federal Reserve. Each living
GLOSSARY 143 will must describe how the company could be Market discipline The idea that markets can resolved in a rapid, orderly way in the event of rein in risk through individual participants failure. behaving in their own interest. This should LTV (loan-to-value) ratio The amount of a loan result in markets pricing risk effectively and as a percent of the estimated value of the asset curbing excessive risk-taking. See moral serving as the loan’s collateral. hazard. Lockdown Stay-at-home orders from a Market liquidity The ability of market government to its citizens. participants to sell large positions with limited price impact and low transaction costs. Macroeconomic risk Risk from changes in the macroeconomy or macroeconomic policy. Market-making The process in which an individual or firm stands ready to buy and sell Macroprudential policy Government policy a particular stock, security, or other asset on promoting the stability of the financial system a regular and continuous basis at a publicly as a whole, in contrast to policy focused on quoted bid-ask prices. Market-makers usually individual markets or institutions. hold inventories of the securities in which they Macroprudential supervision Supervision to make markets. Market-making helps to keep promote the stability of the financial system as a financial markets efficient. whole. See microprudential supervision. Market risk The risk that an asset’s price will Main Street Lending Program Lending change and at unexpected magnitudes. facilities created in 2020 to support small Maturity transformation Funding long-term and medium-size businesses and non-profit assets with short-term liabilities. This practice organizations and their employees. These creates a maturity mismatch that can pose facilities include the Main Street New Loan risks when short-term funding markets are Facility, the Main Street Expanded Loan Facility, constrained. the Main Street Priority Loan Facility, the Nonprofit New Loan Facility, and the Nonprofit Metadata Data about data. Metadata include Expanded Loan Facility. information about the structure, format, or organization of other data. Margin call A requirement by a creditor that a borrower increase the collateral pledged Metadata catalog An organized way to present against a loan in response to reductions in the metadata for discovery, exploration, and use of collateral’s value. the related data. Margin requirement Rules governing the Microprudential supervision Supervision necessary collateral for a derivative, loan, or of the activities of a bank, financial firm, or related security intended to cover, in whole other components of a financial system. See or in part, the credit risk one party poses to macroprudential supervision. another. Monetary policy Government or central bank Mark to market Accounting for the value of an use of interest rates and money supply or asset asset at its current market price rather than in purchases to affect the economy. other ways, such as historical cost. Money market fund A fund that typically invests in short-term government securities, certificates of deposit, commercial paper, or other highly liquid and low-risk securities.
144 OFR ANNUAL REPORT TO CONGRESS 2020 Money Market Mutual Fund Liquidity Facility standards, guidelines, and practices, for (MMLF) A facility established in 2020 to allow critical infrastructure organizations to better the Federal Reserve Bank of Boston to provide manage and reduce cybersecurity risk. The loans to eligible financial institutions to purchase framework focuses on using business drivers to assets from certain types of money market guide cybersecurity activities and considering funds. cybersecurity risks as part of an organization’s Moral hazard When people do not guard risk management process. against risk because they expect someone else Nationally Recognized Statistical Rating to pay for the losses arising from that risk. Organization (NRSRO) Credit rating agency Mortgage call report A quarterly report of registered with and regulated by the SEC. mortgage activity and company information Net asset value (NAV) The value of an entity’s created by state regulators and administered assets minus its liabilities per share. For electronically through the Nationwide Mortgage example, a mutual fund calculates its NAV daily Licensing System & Registry (NMLS). by dividing the fund’s net value by the number Municipal Liquidity Facility (MLF) A program of outstanding shares. created in 2020 to allow the Federal Reserve to Network model A model consisting of a set buy short-term debt issued by state and local of nodes, or financial institutions, and a set of governments with loss protection provided by payment obligations linking them, to show how the U.S. Treasury. financial interconnections can amplify market Multilateral organizations Organizations movements. formed by multiple countries to address Non-investment grade debt Instruments international problems. Examples include the rated below investment grade that pay a higher World Bank and the International Monetary interest rate than investment-grade securities Fund. because of the perceived greater credit risk; also Mutual fund A pooled investment vehicle that known as speculative or high-yield debt. can invest in stocks, bonds, money market Nonprofit New Loan Facility; Nonprofit instruments, other securities, or cash, and sell its Expanded Loan Facility Facilities created by own shares to the public; regulated by the SEC. the Federal Reserve in the summer of 2020 to Narrow spread A small difference between lend money to nonprofit organizations. buyers’ and sellers’ prices (the bid-ask) in a Notional derivatives exposure The reference liquid market. amount from which contractual payments will be National Association of Insurance calculated on a derivatives contract; generally Commissioners (NAIC) An organization that not an amount at risk. represents U.S. state insurance regulators. Off-balance-sheet Assets or entities that are not Through the NAIC, regulators establish recorded on a company’s balance sheet. Rather, accreditation standards and practices, conduct they are explained only in notes to financial peer review, and coordinate their regulatory statements. oversights of insurance companies. Off-the-run Treasury securities Treasury National Institute of Standards and securities outstanding in the market that Technology (NIST) Cybersecurity Framework precede the most recent issue, usually traded Voluntary guidance, based on existing less frequently than on-the-run securities.
GLOSSARY 145 On-the-run Treasury securities The most insurance group to assess the adequacy of its recently issued Treasury securities. These are risk management and current and prospective often traded more frequently than their off-the- solvency positions under normal and severe run predecessors. stress scenarios. Operational risk The risk of loss from internal Pandemic A disease or illness that affects a control inadequacies or failures — problems of significant portion of the globe. lapses by people, processes, or systems — or Passporting Legal arrangement that allows from external events. firms from European Union nations to sell Option A financial contract granting the holder their services across the Union without having the right, but not the obligation, to engage in to comply with each country’s separate a future transaction on an underlying security regulations. or real asset. For example, an equity call option Pension Benefit Guaranty Corporation provides the right, but not the obligation, for a (PBGC) Agency that insures pension benefits; fixed period to buy a block of shares at a fixed it has two programs, one for single-employer price. A put option provides the right, but not pension plans and one for multiemployer plans, the obligation, to sell an asset for a fixed period to pay benefits to retirees in private, defined- at a fixed price. benefit pension plans when sponsors cannot Orderly liquidation authority (OLA) Provision pay. in the Dodd-Frank Act that allows the Federal Pension funded ratio The ratio of a pension Deposit Insurance Corporation to unwind a plan’s assets to the present value of its large, complex company. An OLA serves as a obligations. backup to bankruptcy court proceedings. Pension Obligation Bonds (POBs) Taxable Originate To extend credit after processing a municipal securities issued by state or local loan application. Banks, for example, originate governments to borrow to meet pension mortgage loans and either hold them or sell obligations. them to other financial market participants. Paycheck Protection Program Liquidity The distribution can include a direct sale or a Facility (PPPLF) A program for the securitization. Federal Reserve to extend credit to Over-the-counter (OTC) derivatives lenders participating in the Small Business Derivatives contracts negotiated privately Administration’s Paycheck Protection Program, between two parties, rather than traded on a which provides potentially forgivable loans to formal securities exchange. Unlike standard small businesses to fund their payrolls. exchange-traded products, OTC derivatives Pension risk transfer The transfer of can be tailored to fit specific needs, such as the pension risk from a pension plan to another effect of a foreign exchange rate or commodity party, usually through insurance or annuity price over a given period. contracts, longevity swaps, or other contractual Overnight Indexed Swap (OIS) An interest arrangements. rate swap in which a fixed-rate price index is Pipeline risk The risk that loans being swapped against the overnight reference rate. accumulated for sale cannot be sold at the Own Risk and Solvency Assessment (ORSA) expected prices or at all. An internal process undertaken by an insurer or
146 OFR ANNUAL REPORT TO CONGRESS 2020 Price discovery The process of determining the Regulation SCI A regulation adopted by the prices of assets in the marketplace through the Securities and Exchange Commission that interactions of buyers and sellers. applies to entities that directly support six Primary Credit Rate The interest rate the key securities market functions: (1) trading, (2) Federal Reserve charges banks for discount clearance and settlement, (3) order routing, window borrowings. (4) market data, (5) market regulation, and (6) market surveillance. Primary dealer Banks and securities broker- dealers designated by the Federal Reserve Reinsurance The risk management practice of Bank of New York (FRBNY) to serve as trading insurers to transfer some of their policy risk to counterparties when it carries out U.S. monetary other insurers. A second insurer, for example, policy. Among other things, primary dealers are could assume the portion of liability in return required to participate in all auctions of U.S. for a proportional amount of the premium government debt and to make markets for the income. FRBNY when it transacts on behalf of its foreign Repo Short form of repurchase agreement. official accountholders. A primary dealer buys Repurchase agreement (repo) A transaction in government securities directly and can sell which one party sells a security to another party them to other market participants. and agrees to repurchase it at a certain date in Primary Dealer Credit Facility (PDCF) A the future at an agreed price. Banks often do facility for the Federal Reserve Bank of New this on an overnight basis. A repo is similar to a York to make collateralized loans to primary collateralized loan. dealers, which are the banks and securities Reserve requirements The funds banks are broker-dealers designated to serve as trading required to hold on deposit with the Federal counterparties in carrying out U.S. monetary Reserve. policy. Residential mortgage-backed securities Primary Market Corporate Credit Facility (RMBS) A security that is collateralized by (PMCCF) A Federal Reserve facility to provide a pool of residential mortgage loans and credit to, and purchase new bonds from, large makes payments derived from the interest and investment-grade corporations. principal payments on the underlying mortgage Prime broker Companies that provide hedge loans. funds and other investors with services such as Resilience Ability of the financial system or lending cash and securities. parts of the system to absorb shocks and Qualifying hedge fund Hedge fund advised continue to provide basic functions. by a large hedge fund adviser and with a net Resolution plans Plans required of U.S. banks asset value of at least $500 million. Large with $50 billion or more in total consolidated hedge fund advisers are advisers that have at assets and nonbank financial companies least $1.5 billion in hedge fund assets under designated by the Financial Stability Oversight management. Council for supervision by the Federal Reserve. Real estate investment trust (REIT) Each plan, or living will, must describe how the Corporations that invest in income-producing company could be resolved in a rapid, orderly real estate and pay most of their taxable way in the event of failure. See living wills. income to shareholders as dividends.
GLOSSARY 147 Risk assets Assets that carry risk of default. and WorldCom. The law laid out numerous Such assets include loans, bonds, commodities, accounting and accountability requirements for and other investment vehicles. U.S. Treasury companies, managers, and accountants. securities are generally considered free of Search for yield (reach for yield) Accepting default risk. greater risks in hopes of earning higher returns Risk management The business and regulatory when interest rates on high-quality investments practice of identifying and measuring risks and are low. developing strategies and procedures to limit Secondary Market Corporate Credit Facility them. Categories of risk include credit, market, (SMCCF) A Federal Reserve facility to support liquidity, operations, model, and regulatory. trading of outstanding corporate bonds and Risk retention When issuers of asset-backed corporate bond exchange-traded funds. securities must retain at least part of the credit Section 13(3) authority A section of the Federal risk of the assets collateralizing the securities. Reserve Act that allows emergency lending from The regulation also prohibits a securitizer from the Federal Reserve to financial institutions and directly or indirectly hedging the credit risk. others in “unusual and exigent circumstances” Risk spreads The difference in yields of riskier with the approval of the Secretary of the assets versus perceived safer assets such as Treasury. Treasuries and bank deposits. Secured Overnight Financing Rate (SOFR) Risk-based capital Amount of capital a financial Interest rate benchmark used as an alternative institution holds to protect against losses to LIBOR to set rates on financial products. The based on the risk weighting of different asset SOFR, which is based on repurchase agreement categories. (repo) rates, reflects the general cost of large Risk-weighted assets Bank assets or off- bank borrowing that is backed by Treasury balance-sheet exposures weighted according securities as collateral. The OFR’s repo data to risk categories. This asset measure is used to collection supports the production of the SOFR. determine a bank’s regulatory risk-based capital Securities lending/borrowing The temporary requirements. transfer of securities from one party to another Runnable funding Funds that can be withdrawn for a specified fee and time period in exchange from a financial institution on short notice. for collateral in the form of cash or securities. Uninsured bank deposits, shares of money Securities Information Processors (SIPs) market funds, wholesale borrowings, commercial Established by Congress and the SEC, the SIPs paper, and repurchase agreements are among link the activities of U.S. markets into a single runnable sources of funding. data feed. Run risk The risk that investors lose confidence Securitization A financial transaction in which in a market participant because of concerns assets such as mortgage loans are pooled, about solvency or related issues and respond by securities representing interests in the pool pulling back their funding or demanding more are issued, and proceeds from the underlying margin or collateral. pooled assets are used to service and repay the Sarbanes-Oxley Act of 2002 Law aimed at securities. curbing corporate fraud exposed in several Settlement The process of transferring financial scandals, including those at Enron securities and settling by book entry according
148 OFR ANNUAL REPORT TO CONGRESS 2020 to a set of exchange rules. Some settlement markets. Under the Dodd-Frank Act, banking systems can include institutional arrangements regulators run annual stress tests of the largest for confirmation, clearance, and settlement of U.S. bank holding companies. securities trades and safekeeping of securities. Subcommittee on Quantum Information Shadow banking Credit intermediation Science within the National Science and performed by nonbank companies or financed Technology Council (SCQIS) The SCQIS by runnable liabilities without a government coordinates federal research and development guarantee. in quantum information science and related Shock A sudden change in fundamental technologies under the auspices of the economic drivers and expectations that can executive branch’s National Science and stress the economy and financial system. Technology Council’s Committee on Science. Single-name CDS A credit default swap where Supplementary leverage ratio Under Basel III, the underlying instrument is tied to one specific the ratio of a bank’s Tier 1 (high-quality) capital issuer or entity. to its total leverage exposure, which includes all on-balance-sheet assets and many off-balance- Skin in the game When originators of loans or sheet exposures. other risky instruments keep at least part of the risk for themselves. Swap An exchange of cash flows agreed by two parties with defined terms over a fixed period. Spread The difference in yields between private debt instruments and government securities of Swap Data Repository (SDR) A central comparable maturity. recordkeeping facility that collects and maintains a database of swap transaction SRISK A systemic risk indicator based on the terms, conditions, and other information. In capital that a firm is expected to need if there is some countries, SDRs are referred to as trade another financial crisis; short for “systemic risk.” repositories. Stable net asset value A characteristic of Swap execution facility A trading platform some money market funds in which the value market participants use to execute and trade of a single share remains the same, usually $1, swaps by accepting bids and offers made by even when the value of the underlying assets other participants. shifts. Society for Worldwide Interbank Financial Stablecoin Variety of cryptocurrency that seeks Telecommunications (SWIFT) Provides to maintain a fixed value backed by reserves. messaging services and interface software Standing facilities Operations to execute between wholesale financial institutions. SWIFT monetary policies of the Federal Reserve and is organized as a cooperative owned by its European Central Banks. members. Stimulus A fiscal or monetary policy to increase Syndicated loans Financing provided by a the cash flow in circulation and boost the group of lenders. economy. Systemic risk Risk to systemwide financial Stress test An exercise that shocks asset prices stability. by a prespecified amount, sometimes along Systemic risk indicators Measures of the risks with other financial and economic variables, to financial firms may pose to the financial system. estimate the effect on financial institutions or
GLOSSARY 149 Tail risk The perceived low-probability risk of an U.S. dollar swap line arrangements Standing extreme event or outcome. facilities with the Federal Reserve that allow key TED spread The difference between three- central banks to exchange domestic currency for month U.S. dollar LIBOR and Treasury bill rates. U.S. dollars to satisfy dollar liquidity demand in their own markets. Ten-year, 10-year forward rate The interest rate investors expect to receive on 10-year Value-at-Risk (VaR) A tool for market risk Treasury securities in 10 years. management that measures the risk of loss of a portfolio. The VaR projects the maximum Term Asset-Backed Securities Loan Facility expected loss for a given time horizon and (TALF) A Federal Reserve facility to finance probability. For example, the VaR over 10 days asset-backed securities, such as securitized and with 99 percent certainty measures the most equipment leases, as well as credit card, auto, one would expect to lose over a 10-day period, and other loans. 99 percent of the time. The problem is the other Tier 1 Capital Ratio and Common Equity Tier one percent, see tail risk. 1 Capital Ratio Two measurements comparing a Variable annuity A tax-deferred insurance bank’s capital to its risk-weighted assets to show company contract where the owner can choose its ability to absorb unexpected losses. Tier 1 investment options whose values fluctuate with capital includes common stock, preferred stock, the underlying securities, much like mutual and retained earnings. Common Equity Tier 1 funds. Variable annuities may also include capital excludes preferred stock. guarantees of minimum payments, which may “Too Big To Fail” (TBTF) The belief that the exceed the value of the investment accounts. biggest financial firms will always be bailed out Variation margin Payment made by clearing by the government if necessary. In 1984, the members to the clearinghouse based on price Comptroller of the Currency stated that the 11 movements of the contracts these members largest banks could not be allowed to fail. hold. See initial margin. Total Loss-absorbing Capacity (TLAC) A VIX Chicago Board Option Exchange (CBOE) mix of long-term debt and equity that global Volatility Index, a measure of 30-day expected systemically important bank holding companies volatility in the U.S. stock market. are required to have to absorb losses and implement an orderly resolution without Volcker Rule Provision of Dodd-Frank Act that resorting to taxpayer-funded bailouts or limits proprietary trading by commercial banks extraordinary government measures. and their affiliates. Tranche A portion of a securitized asset pool. Vulnerabilities Underlying weaknesses that From the French word meaning “slice.” can render the financial system susceptible to instability. Triparty repo A repurchase agreement in which a third party, such as a clearing bank, acts Warehouse loans A line of credit with a bank as an intermediary for the exchange of cash for nonbank lenders to use mortgages being and collateral between two counterparties. In accumulated for sale as collateral. addition to providing operational services to participants, agents in the U.S. triparty repo market extend intraday credit to facilitate settlement of triparty repos.
150 OFR ANNUAL REPORT TO CONGRESS 2020 Weekly Economic Index A Federal Reserve index of 10 daily and weekly economic indicators. It reflects what annualized percent change in gross domestic product would be if conditions persisted for a quarter. Wholesale funding Bank funding provided by federal funds borrowing, repurchase agreements, foreign deposits, brokered deposits, and other short-term borrowing. Wholesale funding is considered less stable than funding provided by core deposits. Work from home (WFH) Historically an unconventional alternative to working in corporate office space. As a result of COVID-19 and various lockdowns, WFH increased in 2020. WFH is possibly a long-term trend with significant implications for commercial real estate, telecommunications, and other sectors. Yield curve Graphical representation of the relationship between bond yields and their respective maturities. Generally, the curve slants up because longer-term bonds have higher yields than short-term debt securities. When that relationship does not hold, the yield curve is said to be inverted or flat. Zero lower bound Previously, zero was said to be the lowest interest rate possible, constraining options for monetary policy. Negative interest rates are now common internationally, though not in the United States.
GLOSSARY 151
ENDNOTES
1 Council of Economic Advisers, “Mitigating the Impact of Pandemic Influenza Through Vaccine Innovation,” report to the President, September 2019. https://www.whitehouse.gov/wp-content/uploads/2019/09/Mitigating- the-Impact-of-Pandemic-Influenza-through-Vaccine-Innovation.pdf.
2 Richard Sylla, “Schumpeter Redux: A Review of Raghuram G. Rajan and Luigi Zingales’s Saving Capitalism from the Capitalists,” Journal of Economic Literature 44, no. 2 (June 2006): 391-404, on 393-394. https://www. aeaweb.org/articles?id=10.1257/jel.44.2.391.
3 William C. Dudley, “Financial Stability and Economic Growth,” remarks at the 2011 Bretton Woods Committee International Council Meeting, Sept. 23, 2011. https://www.newyorkfed.org/newsevents/speeches/2011/ dud110923.
4 The White House, “The U.S. Financial Services Sector,” in Economic Report of the President (Washington: Government Printing Office, February 2006), 195-210. https://www.govinfo.gov/content/pkg/ERP-2006/pdf/ERP- 2006.pdf.
5 See numerous working papers listed at: National Bureau of Economic Research, “Working Papers on Pandemic-Related Research, by Topic,” online content, updated frequently. https://nber.org/wp_covid19.html.
6 Offering an extremely bold prediction at the Federal Reserve’s 2005 conference in Jackson Hole, Wyo., Raghuram Rajan warned about what he saw at the time as the perils of weakened market discipline. Subsequently, the 2006 Economic Report of the President underlined this concern by highlighting, for example, that, “The capital- to-asset ratios (measures of the financial cushion available to absorb portfolio losses without becoming insolvent) of Fannie and Freddie are roughly half the average capital-to-asset ratios at comparable financial institutions.” The subprime mortgage crisis was underway by early 2007.
7 American Enterprise Institute, “The International Monetary Fund’s COVID-19 Challenge with Geoffrey Okamoto,” webinar, June 18, 2020. https://www.youtube.com/watch?v=zJfhfrbjdlQ.
8 The White House, “U.S. Unemployment Rate Falls to 50-Year Low,” Oct. 4, 2019. https://www.whitehouse. gov/articles/u-s-unemployment-rate-falls-50-year-low/; Bureau of Labor Statistics, “Civilian unemployment rate,” online content, accessed June 9, 2020. https://www.bls.gov/charts/employment-situation/civilian-unemployment- rate.htm#.
9 Norman Miller, “How Factories Change Production to Quickly Fight Coronavirus,” BBC, April 13, 2020. https://www.bbc.com/worklife/article/20200413-how-factories-change-production-to-quickly-fight-coronavirus.
10 STR, “U.S. Hotel Results for Week Ending 21 March,” news release, March 25, 2020. https://str.com/press- release/str-us-hotel-results-week-ending-21-march; STR, “U.S. Hotel Results for Week Ending 7 March,” news release, March 11, 2020. https://str.com/press-release/str-us-hotel-results-week-ending-7-march.
ENDNOTES 153 11 STR, “U.S. Hotel Profits Fell 101.7% in March,” news release, April 29, 2020.https://str.com/press-release/ str-us-hotel-profits-fell-101-point-7-march.
12 Dun & Bradstreet, “Business Impact of the Coronavirus: Business and Supply Chain Analysis Due to the Coronavirus Outbreak,” February 2020. https://dnbuae.com/public/uploads/editor-images/files/DNB_Business_ Impact_of_the_Coronavirus%20%281%29.pdf.
13 Adnan Seric, Holger Görg, Saskia Mösle, and Michael Windisch, “Managing COVID-19: How the Pandemic Disrupts Global Value Chains,” United Nations Industrial Development Organization, April 2020. https://iap.unido. org/articles/managing-covid-19-how-pandemic-disrupts-global-value-chains.
14 Bureau of Labor Statistics, “Employment Situation News Release,” June 5, 2020, reissued Sept. 23, 2020. https://www.bls.gov/news.release/archives/empsit_06052020.htm.
15 National Bureau of Economic Research, “Determination of the February 2020 Peak in US Economic Activity,” online content, June 8, 2020. https://www.nber.org/cycles/june2020.html.
16 International Monetary Fund (IMF), World Economic Outlook Update: October 2020 (Washington: IMF, October 2020). https://www.imf.org/en/Publications/WEO/Issues/2020/09/30/world-economic-outlook- october-2020.
17 Laura He, “China’s Economy Just Shrank for the First Time in Decades. It Could Still Eke Out Growth This Year,” CNN, April 17, 2020. https://www.cnn.com/2020/04/16/economy/china-economy-gdp/index.html; see also National Bureau of Statistics of China, “Decline of Major Economic Indicators Significantly Narrowed Down in March,” news release, April 17, 2020. http://www.stats.gov.cn/english/PressRelease/202004/t20200417_1739339. html.
18 Growth fell 12.1 percent in the eurozone and 11.9 percent in the EU from the first quarter of 2020 to the second quarter, according to preliminary estimates. See Eurostat, “Preliminary Flash Estimate for the Second Quarter of 2020,” news release, July 31, 2020. https://ec.europa.eu/eurostat/documents/2995521/11156775/2- 31072020-BP-EN.pdf/cbe7522c-ebfa-ef08-be60-b1c9d1bd385b.
19 International Monetary Fund Group of Twenty, “COVID-19 – Impact and Policy Considerations,” G-20 Surveillance Note, April 2020. https://www.imf.org/external/np/g20/pdf/2020/041520.pdf
20 The Federal Reserve changed its inflation targeting framework. See Board of Governors of the Federal Reserve System, “Statement on Longer-run Goals and Monetary Policy Strategy,” amended Aug. 27, 2020. https:// www.federalreserve.gov/monetarypolicy/review-of-monetary-policy-strategy-tools-and-communications-statement- on-longer-run-goals-monetary-policy-strategy.htm.
21 Nicholas Bloom, “The Impact of Uncertainty Shocks,” Econometrica 77, no. 3 (May 21, 2009): 623-685. https://doi.org/10.3982/ECTA6248.
22 Lawrence J. Christiano, Roberto Motto, and Massimo Rostagno, “Risk Shocks,” American Economic Review 104, no. 1 (January 2014): 27–65. https://www.aeaweb.org/articles?id=10.1257/aer.104.1.27.
154 OFR ANNUAL REPORT TO CONGRESS 2020 23 Board of Governors of the Federal Reserve System, “Federal Reserve Board Releases Hypothetical Scenarios for Its 2020 Stress Test Exercises,” news release, Feb. 6, 2020. https://www.federalreserve.gov/newsevents/ pressreleases/bcreg20200206a.htm.
24 Board of Governors of the Federal Reserve System, “The April Senior Loan Officer Opinion Survey on Bank Lending Practices,” May 4, 2020. https://www.federalreserve.gov/data/sloos/sloos-202004.htm; “The July 2020 Senior Loan Officer Opinion Survey on Bank Lending Practices,” Aug. 3, 2020. https://www.federalreserve.gov/data/ sloos/sloos-202007.htm; and “September 2020 Senior Loan Officer Opinion Survey on Bank Lending Practices,” Sept. 29, 2020. https://www.federalreserve.gov/data/sloos/sloos-202009.htm.
25 Mortgage Bankers Association, “Mortgage Delinquencies Spike in the Second Quarter of 2020,” news release, Aug. 17, 2020. https://www.mba.org/2020-press-releases/august/mortgage-delinquencies-spike-in-the- second-quarter-of-2020.
26 The $3.6 trillion total includes $2.5 trillion in leveraged loans and $1.1 trillion in high-yield bonds. Data are aggregated from S&P Leveraged Commentary and Data, Preqin, Shared National Credit Program, and ICE Data Services.
27 Moody’s Investors Service, “August 2020 Default Report.”
28 Moody’s Investors Service, “July 2020 Default Report.”
29 Moody’s Investors Service, “August 2020 Default Report.”
30 Epiq Systems, Inc., “AACER Commercial Filings: Commercial Filings Report,” online content, July 2020. https://www.epiqglobal.com/en-us/experience/restructuring-bankruptcy/aacer-court-data-and-process-automation/ services/bankruptcy-statistics-trends.
31 David Skeel, “Bankruptcy and the Coronavirus,” Brookings Institution, April 21, 2020. https://www. brookings.edu/research/bankruptcy-and-the-coronavirus/.
32 Wells Fargo Securities, “U.S. and Euro Outstanding Market Size,” data provided to OFR staff via S&P Global Market Intelligence, 2020.
33 Jennifer Johnson, Jean-Baptiste Carelus, Eric Kolchinsky, Hankook Lee, Michele Wong, and Elizabeth Muroski, “Collateralized Loan Obligations — Stress Testing U.S. Insurers’ Year-end 2019 Exposure,” National Association of Insurance Commissioners Capital Markets Special Report, June 18, 2020. https://www.naic.org/ capital_markets_archive/special_report_200618.pdf ; Moody’s Investors Service, “CLOs—US and EMEA: Shape of Downturn, Position in Capital Structure Will Influence Collateral Defaults’ Effects on CLO Notes.” Sector In-depth, April 17, 2020. https://www.moodys.com/research/CLOs-US-and-EMEA-Shape-of-downturn-position-in-capital-- PBS_1222301; S&P Global Ratings, “Scenario Analysis: How Credit Distress Due to COVID-19 Could Affect U.S. CLO Ratings,” April 24, 2020. https://www.spglobal.com/ratings/en/research/articles/200424-scenario-analysis-how- credit-distress-due-to-covid-19-could-affect-u-s-clo-ratings-11453639.
ENDNOTES 155 34 Federal Deposit Insurance Corporation (FDIC), History of the Eighties – Lessons for the Future (Washington: FDIC, 1997), Vol. 1, Ch. 3. https://www.fdic.gov/bank/historical/history/137_165.pdf.
35 Government Accountability Office, “Financial Institutions: Causes and Consequences of Recent Community Bank Failures,” Testimony Before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, Lawrance L. Evans, Jr., Director Financial Markets and Community Investment, June 13, 2013. https://www.gao.gov/ assets/660/655193.pdf.
36 Jim Costello, “CMBS Distress Is Only the Tip of the Iceberg,” Real Capital Analytics, June 3, 2020. https:// www.rcanalytics.com/tip-iceberg-lending-distress/.
37 Mortgage Bankers Association, “MBA Commercial Real Estate/Multifamily Finance Quarterly Data Book First Quarter 2020,” June 30, 2020. https://mba.informz.net/MBA/data/images/Research/CMF%20 Databook/1Q20CMFDatabook-final.pdf.
38 S&P Global Ratings, “U.S. CMBS Conduit Update Q2 2020: COVID-19 Impact Still Emerging; Questions Remain,” July 16, 2020. https://www.spglobal.com/ratings/en/research/articles/200716-u-s-cmbs-conduit-update- q2-2020-covid-19-impact-still-emerging-questions-remain-11574730.
39 Peter J. Irwin, Nicole Levin Mesard, Edward M. Rishty, and Isaac Stern, “CMBS Loan Workouts During COVID-19: A Borrower’s Perspective,” Debevoise & Plimpton, May 14, 2020. https://www.debevoise.com/insights/ publications/2020/05/cmbs-loan-workouts-during-covid-19.
40 Real Capital Analytics, “Capital Trends: US Big Picture,” February 2020.
41 National Association of Real Estate Investment Trusts, “REIT Industry September 2020 Rent Survey Results,” Sept. 23, 2020. https://www.reit.com/data-research/research/nareit-research/reit-industry-september-rent- collections.
42 National Association of Real Estate Investment Trusts, “REIT Industry September 2020 Rent Survey Results,” Sept. 23, 2020. https://www.reit.com/data-research/research/nareit-research/reit-industry-september-rent- collections.
43 CBRE, “U.S. MarketFlash: Retail-to-Industrial Property Conversions Accelerate,” July 23, 2020. https://www. cbre.us/research-and-reports/US-MarketFlash-Retail-to-Industrial-Property-Conversions-Accelerate.
44 Luis Santiago and Suzanne Kapner, “Which Stores Are Opening or Closing Amid the Covid Retail Shakeout?” The Wall Street Journal, July 16, 2020. https://www.wsj.com/articles/the-coronavirus-retail-shakeout- whos-closing-or-opening-stores-11594897201.
45 Statista, “Retail Space Per Capita in Selected Countries Worldwide in 2018,” Oct. 11, 2018. https://www. statista.com/statistics/1058852/retail-space-per-capita-selected-countries-worldwide/.
46 Trepp LLC, “CMBS Delinquency Rate Surges for the Third Month: Nears All-Time High,” July 2020. https:// info.trepp.com/hubfs/Trepp%20June%202020%20Delinquency%20Report.pdf.
156 OFR ANNUAL REPORT TO CONGRESS 2020 47 STR, “U.S. Hotel Performance for September 2020,” news release, Oct. 20, 2020. https://str.com/press- release/str-us-hotel-performance-september-2020.
48 Moody’s Investors Service, “Consumer Comfort Vital for Travel, Tourism Dependent Sectors’ Eventual Recovery,” Sector In-Depth, Aug. 25, 2020. https://www.moodys.com/researchdocumentcontentpage. aspx?docid=PBC_1229393.
49 Moody’s Investors Service, “Structured Finance — Global: Servicing Policy and Government Mandates Drive Varying Exposure to Payment Moratoriums,” Sector In-Depth, July 22, 2020. https://www.moodys.com/ researchdocumentcontentpage.aspx?docid=PBS_1235167
50 Neil Bhutta, Jacqueline Blair, Lisa Dettling, and Kevin Moore, “COVID-19, the CARES Act, and Families’ Financial Security,” National Tax Journal 73, no. 3 (September 2020): 645-672. dx.doi.org/10.17310/ntj.2020.3.02; earlier version available at SSRN. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3631903
51 Certain reinsurance companies also issue CRT bonds. These companies account for a small amount of total CRT bond issuance. Reinsurance companies also participate in credit risk transfer through the use of reinsurance.
52 Both Fannie Mae and Freddie Mac also engage in transactions designed to transfer part of the credit risk to insurance companies or reinsurers.
53 Fannie Mae, Form 10-Q, Securities and Exchange Commission filing, July 30, 2020, 9.https://www. fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2020/q22020.pdf; Freddie Mac, Form 10-Q, Securities and Exchange Commission filing, July 30, 2020, 2. http://www.freddiemac.com/investors/financials/pdf/10q_2q20. pdf.
54 Federal Housing Finance Agency, “Enterprise Regulatory Capital Framework,” notice of proposed rulemaking: request for comments, Federal Register 85, no. 126 (June 30, 2020): 39274-39406. https://www. govinfo.gov/content/pkg/FR-2020-06-30/pdf/2020-11279.pdf.
55 New Jersey Department of the Treasury, “Governor Signs Bare Bones Spending Plan into Law for Extended Fiscal Year to Help Weather Continued Fallout from COVID-19,” news release, June 30, 2020. https://www.nj.gov/ treasury/news/2020/06302020a.shtml.
56 Bloomberg Finance L.P., Barclays Municipal Total Return Index, using Merrill Lynch’s bond classification, online data, May 2020.
57 Moody’s Investors Service, “U.S. Public Finance: U.S. Municipal Bond Defaults and Recoveries, 1970-2019,” data report, July 15, 2020, 3; S&P Global Ratings, “Credit FAQ: COVID-19, Recession, and U.S. Public Ratings,” May 14, 2020, 8. https://www.spglobal.com/ratings/en/research/articles/200514-credit-faq-covid-19-recession-and- u-s-public-finance-ratings-11489830.
58 Shelly Sigo, “Alabama City’s Woes Predated the Coronavirus and Chapter 9,” The Bond Buyer, May 21, 2020. https://www.bondbuyer.com/news/fairfield-alabama-files-for-chapter-9-bankruptcy.
ENDNOTES 157 59 State and local pension plans that follow Generally Accepted Accounting Principles (GAAP) use accounting and financial reporting standards issued by the Governmental Accounting Standards Board (GASB). Under the GASB standards, the unfunded pension liabilities are reported as being lower than under the Federal Reserve’s reporting standards.
60 Public Plans Data, “National Data,” online content, updated June 29, 2020. https://publicplansdata.org/ quick-facts/national/.
61 State of California Public Employees’ Retirement System, “Board of Administration Investment Committee Open Meeting,” transcript of videoconference meeting, June 15, 2020. https://www.calpers.ca.gov/docs/board- agendas/202006/invest/transcript-ic_a.pdf.
62 Municipalities include cities, towns, villages, counties, taxing districts, municipal utilities, and school districts.
63 Pension Benefit Guaranty Corporation (PBGC),FY 2019 Projections Report (Washington: PBGC, Sept. 14, 2020). https://www.pbgc.gov/sites/default/files/fy-2019-projections-report.pdf.
64 Trieu Pham, Nicholas Mapa, Gustavo Rangel, Prakash Sakpal, and Valentin Tataru, “EM Sovereign Risks: No Time to be Complacent on Fallen Angel Risks,” ING, July 20, 2020. https://think.ing.com/reports/em-sovereign- debt-no-time-to-be-complacent-on-fallen-angel-risks/.
65 France 24, “Italy Approves Long-awaited €55 Billion Bailout Package After Two-month Lockdown,” May 14, 2020. https://www.france24.com/en/20200513-italy-covid-19-coronavirus-giuseppe-conte-stimulus-bailout.
66 Reuters, “Bank of Italy Lowers 2020 GDP Forecast to -9.5%,” July 10, 2020. https://www.reuters.com/article/ us-italy-economy-cenbank/bank-of-italy-lowers-2020-gdp-forecast-to-9-5-idUSKBN24B1UN.
67 Jack Allen-Reynolds, “European Economics Focus: Will Government Debt Be Sustainable After the Crisis?,” Capital Economics, May 20, 2020. https://www.capitaleconomics.com/publications/european-economics/european- economics-focus/will-government-debt-be-sustainable-after-the-crisis/.
68 Silvia Amaro and Christine Wang, “EU Leaders Reach $2 Trillion Deal on Recovery Plan After Marathon Summit,” CNBC, July 20, 2020. https://www.cnbc.com/2020/07/21/eu-leaders-reach-a-breakthrough-on-the- regions-recovery-fund.html.
69 Robin Wigglesworth, Benedict Mander, and Colby Smith, “Argentina Strikes Debt Agreement After Restructuring Breakthrough,” Financial Times, Aug. 4, 2020. https://www.ft.com/content/ecb81529-7853-4403- 95a9-577ee1ebc4b8.
70 Scott R. Baker, Nicholas Bloom, Steven J. Davis, Kyle J. Kost, Marco C. Sammon, and Tasaneeya Viratyosin, “The Unprecedented Stock Market Impact of COVID-19,” NBER Working Paper no. 26945, April 30, 2020. https:// www.nber.org/papers/w26945.
158 OFR ANNUAL REPORT TO CONGRESS 2020 71 On Oct. 27, 1997, the Dow Jones Industrial Average fell 7.2 percent, breaching both circuit breaker levels in place then. The consensus opinion at the time was that the trigger levels were not properly calibrated. The threshold levels were subsequently widened, with the first threshold level set at a 10 percent Dow decline. However, on May 6, 2010, the Dow fell 9.2 percent during the “flash crash” incident and the 10 percent circuit breaker was not triggered. The consensus opinion was that it would have been better if it had been. The threshold levels were narrowed back to 7 percent, and the Dow was replaced by the broader S&P 500 index as the basis for the thresholds.
72 While prime money market funds experienced significant outflows, government and Treasury money market funds had inflows.
73 James Ludden and Erin McClam, “Goldman Sachs Props Own Money-Market Funds After Withdrawals,” Bloomberg, March 22, 2020; Securities and Exchange Commission Forms N-CEN: https://www.sec.gov/Archives/ edgar/data/0000822977/000119312520081669/d895398dncr.htm; https://www.sec.gov/Archives/edgar/data/000 0822977/000119312520080805/d893803dncr.htm; https://www.sec.gov/Archives/edgar/data/0000822977/00011 9312520081672/d895411dncr.htm; https://www.sec.gov/Archives/edgar/data/0000822977/000168386320000866/ f2701d1.htm; https://www.sec.gov/Archives/edgar/data/0000759667/000075966720000007/formn-cr.htm; https:// www.sec.gov/Archives/edgar/data/0000759667/000075966720000006/formn-cr.htm; https://www.sec.gov/Archives/ edgar/data/0000759667/000075966720000004/formn-cr.htm; https://www.sec.gov/Archives/edgar/data/000075966 7/000075966720000005/formn-cr.htm; https://www.sec.gov/Archives/edgar/data/0000831363/00008313632000005 0/formn-cr.htm.
74 Fitch Ratings, “U.S. Prime Money Mkt Fund Outlook Negative on Liquidity Challenges,” March 23, 2020. https://www.fitchratings.com/research/fund-asset-managers/us-prime-money-mkt-fund-outlook-negative-on- liquidity-challenges-23-03-2020.
75 Federal Home Loan Banks Office of Finance, “Federal Home Loan Banks Combined Financial Report for the Quarterly Period Ended June 30, 2020,” Aug. 13, 2020. http://www.fhlb-of.com/ofweb_userWeb/ resources/2020Q2CFR.pdf.
76 Daniel Barth and Jay Kahn, “Basis Trades and Treasury Market Illiquidity,” OFR Brief no. 20-01, July 16, 2020. https://www.financialresearch.gov/briefs/files/OFRBr_2020_01_Basis-Trades.pdf.
77 Board of Governors of the Federal Reserve System, “Temporary Exclusion of U.S. Treasury Securities and Deposits at Federal Reserve Banks from the Supplementary Leverage Ratio,” interim final rule and request for comment, Federal Register 85, no. 72 (April 14, 2020): 20578-20586. https://www.federalregister.gov/ documents/2020/04/14/2020-07345/temporary-exclusion-of-us-treasury-securities-and-deposits-at-federal-reserve- banks-from-the.
78 Board of Governors of the Federal Reserve System, “Temporary Exclusion of U.S. Treasury Securities and Deposits at Federal Reserve Banks from the Supplementary Leverage Ratio,” interim final rule and request for comment, Federal Register 85, no. 72 (April 14, 2020): 20578-20586. https://www.federalregister.gov/ documents/2020/04/14/2020-07345/temporary-exclusion-of-us-treasury-securities-and-deposits-at-federal-reserve- banks-from-the.
ENDNOTES 159 79 A relative-value strategy involves the simultaneous purchase and sale of similar securities whose prices, in the opinion of the trader, are not in sync with what the trader sees as their “true value.” Acting on the assumption that prices will revert to true value over time, the trader will sell short overpriced securities and buy underpriced securities. Once prices revert to true value, the trades can be liquidated at a profit. See Barclay Hedge, “Understanding Relative-Value Arbitrage,” online content, Feb. 1, 2020. https://www.barclayhedge.com/insider/ hedge-fund-strategy-relative-value-arbitrage.
80 Peter Laurelli, “Hedge Funds Continue Rebound from COVID-19 with Positive Flows in August,” eVestment, Sept. 23, 2020. https://www.evestment.com/news/hedge-funds-continue-rebound-from-covid-19-with-positive- flows-in-august/.
81 Amy Whyte, “Hedge Funds Just Had Their Worst Quarter Since 2009,” Institutional Investor, April 22, 2020. https://www.institutionalinvestor.com/article/b1l9qwb5ddjkjr/Hedge-Funds-Just-Had-Their-Worst-Quarter- Since-2009.
82 Daniel Barth and Jay Kahn, “Basis Trades and Treasury Market Illiquidity,” OFR Brief no. 20-01, July 16, 2020. https://www.financialresearch.gov/briefs/2020/07/16/basis-trades-and-treasury-market-illiquidity/.
83 Federal Deposit Insurance Corporation, “FDIC Quarterly Banking Profile,” June 16, 2020, and Aug. 25, 2020. https://www.fdic.gov/bank/analytical/qbp/2020mar/ and https://www.fdic.gov/bank/analytical/qbp/2020jun/ .
84 Based on net income attributable to holding company.
85 Office of the Comptroller of the Currency, “Semiannual Risk Perspective,” Spring 2020.https://www.occ. gov/publications-and-resources/publications/semiannual-risk-perspective/files/pub-semiannual-risk-perspective- spring-2020.pdf.
86 On Sept. 17, 2020, the Federal Reserve announced that a second set of COVID-19 stress tests will be conducted in the fourth quarter of 2020. See Board of Governors of the Federal Reserve System, “Federal Reserve Board Releases Hypothetical Scenarios for Second Round of Bank Stress Tests,” news release, Sept. 17, 2020. https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200917a.htm.
87 Federal Housing Finance Agency, “Enterprise Regulatory Capital Framework,” notice of proposed rulemaking: request for comments, Federal Register 85, no. 126 (June 30, 2020): 39274-39406, https://www. govinfo.gov/content/pkg/FR-2020-06-30/pdf/2020-11279.pdf.
88 Federal Deposit Insurance Corporation, “FDIC Quarterly Banking Profile,” June 16, 2020.https://www.fdic. gov/bank/analytical/qbp/2020mar/.
89 Federal Deposit Insurance Corporation, “FDIC Quarterly Banking Profile,” Aug. 25, 2020.https://www.fdic. gov/bank/analytical/qbp/2020jun/.
90 Financial Accounting Standards Board, “Financial Instruments—Credit Losses (Topic 326),” Accounting Standards Update no. 2016-03, June 2016, 2. https://www.fasb.org/jsp/FASB/Document_C/ DocumentPage?cid=1176168232528&acceptedDisclaimer=true.
160 OFR ANNUAL REPORT TO CONGRESS 2020 91 Zach Fox and Nathaniel Melican, “COVID-19 Provisioning Towers over CECL Build for Most Large Banks,” S&P Market Intelligence, June 29, 2020. https://www.spglobal.com/marketintelligence/en/news-insights/latest- news-headlines/covid-19-provisioning-towers-over-cecl-build-for-most-large-banks-59186338.
92 See OFR Bank Systemic Risk Monitor, OFR Contagion Index tab: https://www.financialresearch.gov/bank- systemic-risk-monitor/ .
93 Financial Stability Board, Key Attributes of Effective Resolution Regimes for Financial Institutions, Chapter 9. (Basel: October 2014). https://www.fsb.org/work-of-the-fsb/policy-development/effective-resolution-regimes-and- policies/key-attributes-of-effective-resolution-regimes-for-financial-institutions/.
94 Jill Cetina, Mark Paddrik, and Sriram Rajan, “Stressed to the Core: Counterparty Concentrations and Systemic Losses in CDS Markets,” OFR Working Paper no. 16-01, March 8, 2016. https://www.financialresearch.gov/ working-papers/2016/03/08/stressed-to-the-core/; Mark Paddrik, Sriram Rajan, and H. Peyton Young, “Contagion in the CDS Market,” OFR Working Paper no. 16-12, Dec. 1, 2016. https://www.financialresearch.gov/working- papers/2016/12/01/contagion-in-the-cds-market/.
95 Jack Ewing and Milan Schreuer, “How a Lone Norwegian Trader Shook the World’s Financial System,” The New York Times, May 3, 2019. https://www.nytimes.com/2019/05/03/business/central-counterparties-financial- meltdown.html.
96 Generally, a supply chain is “a system of organizations, people, activities, information, and resources, possibly international in scope that provides products or services to consumers.” See Computer Security Resource Center, “Glossary,” online content, updated periodically. https://csrc.nist.gov/glossary.
97 Larry Santucci, “Quantifying Cyber Risk in the Financial Services Industry,” Federal Reserve Bank of Philadelphia Discussion Paper no. DP 18-03, November 2018. https://www.philadelphiafed.org/-/media/consumer- finance-institute/payment-cards-center/publications/discussion-papers/2018/dp18-03.pdf?la=en.
98 New York State Department of Financial Services, “Report on Cyber Security in the Banking Sector,” May 2014, 11. https://www.dfs.ny.gov/system/files/documents/2020/03/dfs_cyber_banking_rpt_052014.pdf.
99 John Haller and Charles M. Wallen, Managing Third Party Risk in Financial Services Organizations: A Resilience-Based Approach (Pittsburgh: Carnegie Mellon University Software Engineering Institute, September 2016). https://resources.sei.cmu.edu/asset_files/WhitePaper/2016_019_001_473742.pdf.
100 The chain of dependencies for third-party service providers may create different layers of risk beyond fourth- party risk — such as fifth-, sixth-, and seventh-party risks.
101 National Academies of Sciences, Engineering, and Medicine, “New Cryptography Must Be Developed and Deployed Now, Even Though a Quantum Computer that Could Compromise Today’s Cryptography Is Likely at Least a Decade Away, Says New Report,” news release, Dec. 4, 2018. For technical details, see National Academies of Sciences, Engineering, and Medicine, Quantum Computing: Progress and Prospects (Washington: The National Academies Press, 2019). https://doi.org/10.17226/25196.
ENDNOTES 161 102 Michael J.D. Vermeer and Evan D. Peet, Securing Communications in the Quantum Computing Age: Managing the Risks to Encryption (Santa Monica, Calif.: RAND Corporation, 2020). http://www.rand.org/t/RR3102 .
103 Aon plc, Weather, Climate & Catastrophe Insight — 2019 Annual Report (Chicago: Aon, 2020), 8. http:// thoughtleadership.aon.com/Documents/20200122-if-natcat2020.pdf.
104 Federal Reserve Bank of San Francisco, “The Economics of Climate Change,” agenda of conference hosted by the Federal Reserve Bank of San Francisco, Nov. 8, 2019. https://www.frbsf.org/economic-research/events/2019/ november/economics-of-climate-change/.
105 Financial Stability Board (FSB), Stocktake of Financial Authorities’ Experience in Including Physical and Transition Climate Risks as Part of Their Financial Stability Monitoring (Basel: FSB, July 22, 2020). https://www.fsb. org/wp-content/uploads/P220720.pdf.
106 Robert B. Laughlin, “What the Earth Knows,” The American Scholar, June 1, 2010. https:// theamericanscholar.org/what-the-earth-knows/#.X0VxJphKg2w.
107 Ker Than, “Scientists: Natural Disasters Becoming More Common,” Live Science, Oct. 17, 2005. https:// www.livescience.com/414-scientists-natural-disasters-common.html.
108 Daniel Staib, Caroline De Souza Rodrigues Cabral, Daniel Kubli, and Jürgen Dornigg, “World Insurance: Riding Out the 2020 Pandemic Storm,” Swiss Re, July 9, 2020, 18. https://www.swissre.com/institute/research/ sigma-research/sigma-2020-04.html.
109 American Property Casualty Insurance Association, National Association of Mutual Insurance Companies, and Independent Insurance Agents & Brokers of America, “Business Continuity Protection Program,” member advisory, May 21, 2020. https://www.namic.org/pdf/20memberadvisory/200521_apcia_namic_big_bcpp_summary. pdf.
110 Richard Fox, Letter from Richard Fox, Head of Markets Policy, The Financial Conduct Authority, to Scott O’Malia and Katherine Darras, International Swaps and Derivatives Association, Jan. 20, 2020. https://www.fca.org. uk/publication/correspondence/letter-isda-unrepresentative-libor.pdf.
111 Christopher S. Schell, Vidal Vanhoof, Adam Schneider, Serge Gwynne, and Ming Min Lee, “LIBOR Fallbacks in Focus: A Lesson in Unintended Consequences,” Oliver Wyman and Davis Polk, 2018. https://www.oliverwyman. com/content/dam/oliver-wyman/v2/publications/2018/may/Oliver%20Wyman%20-%20LIBOR%20Fallbacks%20 in%20Focus.PDF.
112 Alternative Reference Rates Committee, “ARRC Releases a Proposal for New York State Legislation for U.S. Dollar LIBOR Contracts,” news release, March 6, 2020. https://www.newyorkfed.org/medialibrary/Microsites/arrc/ files/2020/ARRC_Press_Release_Proposed_Legislative_Solution.pdf.
113 Alternative Reference Rates Committee, “Transition from LIBOR,” online content, undated, accessed Sept. 26, 2020. https://www.newyorkfed.org/arrc/sofr-transition.
162 OFR ANNUAL REPORT TO CONGRESS 2020 114 Federal Reserve Bank of New York, “Transition from LIBOR: Credit Sensitivity Group Workshops,” online content, updated Aug. 27, 2020. https://www.newyorkfed.org/newsevents/events/markets/2020/0225-2020. Fannie Mae and Freddie Mac will no longer accept adjustable-rate mortgages tied to LIBOR after the end of 2020.
115 Federal Reserve Bank of New York, “Transition from LIBOR: Credit Sensitivity Group Workshops,” online content, updated Aug. 27, 2020. https://www.newyorkfed.org/newsevents/events/markets/2020/0225-2020.
116 Office of Financial Research (OFR),2019 Annual Report (Washington: OFR, Dec. 11, 2019), 40-42. https:// www.financialresearch.gov/annual-reports/2019-annual-report/.
117 European Securities and Markets Authority, “ESMA Tells Market Participants to Continue Preparations for the End of U.K. Transition Period,” news release, July 17, 2020. https://www.esma.europa.eu/press-news/esma- news/esma-tells-market-participants-continue-preparations-end-uk-transition-period.
118 See Matthew Beville, Dino Falaschetti, and Michael J. Orlando, “An Information Market Proposal for Regulating Systemic Risk,” University of Pennsylvania Journal of Business Law 12, no. 3 (Spring 2010): 849-98, https://scholarship.law.upenn.edu/jbl/vol12/iss3/6; and Dino Falaschetti, “Systemic Risk: What Is it, Why Is It Important, and What Can We Do About It?,” Mercatus Center, May 29, 2015, available via SSRN. https://papers. ssrn.com/sol3/papers.cfm?abstract_id=2653771.
119 Earlier sections of this report document prescient warnings of the 2007-09 financial crisis.
120 Kenneth J. Arrow and others, “The Promise of Prediction Markets,” Science 320, no. 5878 (May 16, 2008): 877-878. https://mason.gmu.edu/~rhanson/PromisePredMkt.pdf.
121 Matthew Beville, Dino Falaschetti, and Michael J. Orlando, “An Information Market Proposal for Regulating Systemic Risk,” University of Pennsylvania Journal of Business Law 12, no. 3 (Spring 2010): 849-98, https:// scholarship.law.upenn.edu/jbl/vol12/iss3/6.
122 Erik Snowberg, Justin Wolfers, and Eric Zitzewitz, “Prediction Markets for Economic Forecasting,” The Brookings Institution, June 13, 2012. https://www.brookings.edu/research/prediction-markets-for-economic- forecasting/.
123 Zhang and Zhang (2013) presents empirical evidence that the credit default swap market efficiently incorporates private information. See Gaiyan Zhang and Sanjian Zhang, “Information Efficiency of the U.S. Credit Default Swap Market: Evidence from Earnings Surprises,” Journal of Financial Stability Vol. 9, no. 4 (December 2013): 720-730. http://www.sciencedirect.com/science/article/pii/S1572308911000556.
124 Ip (2015) suggests that rigorous cost-benefit analysis of financial regulation may be altogether absent from related policy deliberations. See Greg Ip, “Missing in Financial Rules Debate: Hard Numbers,” The Wall Street Journal, May 13, 2015. wsj.com/articles/missing-in-financial-rules-debate-hard-numbers-1431545139.
ENDNOTES 163 125 Wagster (1996) uses an event study approach to evaluate the stock market’s expectations of the effects of the Basel Accord on international bank competition. See John D. Wagster, “Impact of the 1988 Basle Accord on International Banks,” Journal of Finance Vol. 51, no. 4 (September 1996): 1321-1346. https://onlinelibrary.wiley. com/doi/10.1111/j.1540-6261.1996.tb04071.x.
126 Summarizing a “large and growing literature,” Calomiris and Haber (2014, pp. 8-9) concludes, “Finance facilitates the efficient operation of all other economic activities.” Giglio, Kelly, and Pruitt (2015) observes, “The ability of financial system stress to trigger sharp macroeconomic downturns has made systemic risk a focal point of research and policy.” See Charles W. Calomiris and Stephen H. Haber, Fragile by Design: The Political Origins of Banking Crises & Scarce Credit (Princeton, N.J.: Princeton University Press, 2014); Stefano Giglio, Bryan Kelly, and Seth Pruitt, “Systemic Risk and the Macroeconomy: An Empirical Evaluation,” Journal of Financial Economics 119, no. 3 (Jan. 22, 2016): 457-471. https://doi.org/10.1016/j.jfineco.2016.01.010.
127 Committee on Capital Markets Regulation, “What to Do About Contagion? A Call by the Committee on Capital Markets Regulation for Public Debate,” Sept. 3, 2014. https://www.capmktsreg.org/wp-content/ uploads/2018/10/What-to-do-About-Contagion.pdf. Stern and Feldman (2004, pp. 45-7) offers a similar taxonomy. See Gary H. Stern and Ron J. Feldman, Too Big to Fail: The Hazards of Bank Bailouts (Washington: Brookings Institution Press, 2004).
128 Interestingly, the widespread use of asset-based capital requirements as a tactic for reducing systemic risk may increase the correlation between banks’ asset holdings, and therefore increase systemic risk. A later section of this chapter further addresses this potential.
129 Cochrane (2014, p. 10) observes that, while “investors in short-term highly rated debt” may normally remain rationally ignorant, “trouble at one bank” may cause them to “start worrying about other similar banks and securities.” See John H. Cochrane, “Toward a Run-Free Financial System,” April 16, 2014, available at SSRN. http:// dx.doi.org/10.2139/ssrn.2425883.
130 A later section of this chapter considers this possibility further.
131 The Iowa Electronic Markets is operational, and lets participants trade securities that pay $1 in the event that candidates from a particular political party win a particular election. A security trading at $0.60 communicates a market forecast that a candidate enjoys a 60 percent chance of winning the specified election.
132 Beville, Falaschetti, and Orlando (2009), among others, reviews the research to this effect. See Matthew Beville, Dino Falaschetti, and Michael J. Orlando, “An Information Market Proposal for Regulating Systemic Risk,” University of Pennsylvania Journal of Business Law 12, no. 3 (Spring 2010): 849-98, https://scholarship.law.upenn. edu/jbl/vol12/iss3/6.
133 Giglio, Kelly, and Pruitt (2015, p. 1) suggests that “(t)he ability of financial system stress to trigger sharp macroeconomic downturns has made systemic risk a focal point of research and policy.” See Stefano Giglio, Bryan Kelly, and Seth Pruitt, “Systemic Risk and the Macroeconomy: An Empirical Evaluation,” Journal of Financial Economics 119, no. 3 (Jan. 22, 2016): 457-471. https://doi.org/10.1016/j.jfineco.2016.01.010.
134 Tom Keene, “On the Economy,” Bloomberg podcast, May 16, 2008.
164 OFR ANNUAL REPORT TO CONGRESS 2020 135 Dependent firms include those that are most likely to transact with a financial services organization. Independent firms tend to be insensitive to the financial sector’s health, except for third-party effects from financial transactions. Rajan and Zingales (1998) estimates these dependencies across economic sectors. Giglio, Kelly, and Pruitt (2015) considers a number of systemic risk measures, and evaluates them against the standard of how well they forecast shocks to the macroeconomy. These measures could also serve as systemic risk indicators for the type of information market contract outlined in this chapter. See Raghuram Rajan and Luigi Zingales, “Financial Dependence and Growth,” American Economic Review 88, no. 3 (June 1998): 559-586. https://www.jstor.org/ stable/116849?seq=1#metadata_info_tab_contents; and Stefano Giglio, Bryan Kelly, and Seth Pruitt, “Systemic Risk and the Macroeconomy: An Empirical Evaluation,” Journal of Financial Economics 119, no. 3 (Jan. 22, 2016): 457- 471. https://doi.org/10.1016/j.jfineco.2016.01.010.
136 Other triggers have also been proposed. Surowiecki (2005), for example, reviews how the number of bank failures could serve as a condition for payoffs, and thus leverage the “wisdom of crowds” to develop new and better information about the prospect of systemic risk. See James Surowiecki, The Wisdom of Crowds (New York: Anchor Books, 2005).
137 At the time of their writing, Beville, Falaschetti, and Orlando (2009) did not have access to data beyond the first quarter of 2009. See Matthew Beville, Dino Falaschetti, and Michael J. Orlando, “An Information Market Proposal for Regulating Systemic Risk,” University of Pennsylvania Journal of Business Law 12, no. 3 (Spring 2010): 849-98, https://scholarship.law.upenn.edu/jbl/vol12/iss3/6.
138 Michael Abramowicz, “Information Markets, Administrative Decisionmaking, and Predictive Cost-Benefit Analysis,” University of Chicago Law Review 71, no. 3 (2004): 933-1020. https://chicagounbound.uchicago.edu/ uclrev/vol71/iss3/3/.
139 Peter H. Diamandis and Steven Kotler, Abundance: The Future is Better Than You Think (New York: Free Press, 2015), 13.
140 The Economic Report of the President (2006, p. 201) highlighted the potential for financial services to “encourage the replacement of outdated and inefficient technologies,” the absence of which could constrain individuals to “pursue innovations only when they have enough resources to get their projects off the ground” (italics added). These “‘Idea-rich’ but ‘capital-poor’ innovators pose little threat to a market’s incumbents … By easing the way for newcomers to participate in the economy, financial services can hasten the replacement of bad ideas with growing opportunities.” See The White House, Economic Report of the President (Washington: Government Printing Office, February 2006). https://www.govinfo.gov/content/pkg/ERP-2006/pdf/ERP-2006.pdf
ENDNOTES 165
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